The Difference Between Hedge Funds and Mutual Funds

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You keep hearing about these big hedge funds making big bets on stocks, but you're only invested in mutual funds.

They both pool together money from a group of investors and manage the total chunk of money by buying and selling securities -- stocks if it's an equity fund, bonds if its a fixed-income fund and so on.

Sounds like a lot. Don't worry. We're going to explain the basics first and then get into the differences.

In any fund, investors share the profits they're entitled to. If $100 goes into a fund and Max put in $10 and Laura put in $12, Max owns 10% of the returns and Laura owns 12%. The rest of the investors combine for the remaining 78%. If the funds investments rise in value, maybe the total amount managed by the fund rises to $110. Max owns 10% of that, so he owns $11 of that value.

But the company running the fund needs to get paid, right? So the fund charges its investors a small fixed percent of the assets under its management per year. And every time the fund managers sell a holding for a gain, the fund keeps a slightly higher percent than that fixed fee on the gain. The rest is for the investors, so Max's actual value is slightly below $11.

Hedge funds, mutual funds -- doesn't matter. This is the way investment funds work.

Hedge funds are for accredited investors, or those that securities regulators deem sophisticated enough to invest in certain types of funds. These are institutional investors, which include university endowments, state pensions, financial institutions and high net worth people and families.

Most of these parties have growing budgets and financial needs. They need a strong rate of return. Hedge funds invest aggressively, looking for opportunities to outperform the broader market in quick time, either by holding a long position on an undervalued security or a short position on an overvalued security. To protect against their downside, they often buy options against their positions.

Mutual funds function differently.

To see how, watch the quick video above. 

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