Both hedge funds and mutual funds are investment funds designed to provide return opportunities for investors through professional management and diversification among holdings.
What Is a Mutual Fund?
Mutual funds are professionally managed funds that are typically managed to a specific investment style and are often focused on specific asset classes. There are mutual funds that invest in stocks, bonds, money market instruments and in combinations of one of more of these. Some mutual funds are actively managed, meaning the manager decides which specific securities to own within the fund and which securities to exclude from it. Others are passively managed, these funds are known as index funds. These mutual funds generally track an index or market benchmark like the S&P 500 or the Russell 2000.
Mutual funds are easily available to investors via many brokerage platforms and directly from the mutual fund company via their site in many cases. Some funds are also sold through brokers and registered reps as well; these are generally mutual funds that carry a sales charge.
When most of us think of mutual funds we think of open-end funds. Open-end mutual funds allow investors to purchase new shares of the fund as long as the fund is open to new investors. On the other hand, closed-end mutual funds have a finite number of shares that are traded on the stock exchange on a daily basis. New shares are only created if the fund company issues these additional shares at some point.
Both open-end and closed-end mutual funds are governed by the Securities Act of 1933 and Investment Company Act of 1940, both administered by the Securities and Exchange Commission.
What Is a Hedge Fund?
Hedge funds are pooled accounts that are offered privately to investors. They are generally set up as partnerships that offer higher risk and often more focused investment strategies to investors. The premise is that investors will be rewarded with higher returns in exchange for taking these higher risks. This does happen at times, in other cases it may not. It depends on the quality of the fund’s management and the validity of their investing strategy.
Unlike mutual funds, hedge funds are not readily available to the investing public. Because of the fact that hedge funds offer their investments privately, they are subject to the rules of Regulation D of the Securities Act of 1933. This means that the fund can only be offered to accredited investors as defined by the SEC. Accredited investors include high net worth individuals, banks, insurance companies, brokers, trusts and other institutional investors.
For an individual investor to be considered an accredited investor, they must have an income of at least $200,000 for an individual or $300,000 for those with joint income for a period of at least two years with the expectation that this will continue into the future. A person with a net worth of at least $1 million either as an individual or jointly with their spouse would also be considered an accredited investor.
Hedge Funds vs. Mutual Funds: Similarities and Differences
There are a number of similarities between the two types of funds:
- Both hedge funds and mutual funds are pooled investment vehicles that invest the money of a number of investors in one portfolio.
- Both hedge fund and mutual funds provide investors with a degree of diversification in terms of holding multiple securities aligned with the fund’s objective, versus just holding one or a few securities. The degree of diversification will vary widely among funds. Some mutual funds and hedge funds may be highly concentrated in a single sector or they may hold a concentrated position in just a few securities. Mutual funds will often be focused on a single market sector or asset class, hedge funds will often spread their holding over a number of sectors.
- Both mutual funds and hedge funds are professionally managed, the managers pick the securities to be held in the fund. Hedge funds are generally actively managed, meaning the manager buys and sells securities based on their analysis, market outlook and other factors. Some mutual funds are actively managed, others are passively managed, focusing on tracking an index. In the case of an index mutual fund, the managers still oversee the fund to ensure that its portfolio tracks the index, making periodic adjustments to keep the portfolio in line.
- Both mutual funds and hedge funds have underlying expenses that investors need to be aware of. In the case of mutual funds there is an expense ratio, in some cases there may also be up-front or back-end sales charges as well. In the case of a hedge fund there is typically an annual management fee plus a performance fee if certain objectives are met. The fees on hedge funds can often be quite steep. With both types of funds it's important for investors to understand the costs and weigh them against both the potential returns and other funds and investments they might be considering.
Some differences between hedge funds and mutual funds include:
- Mutual funds are readily available to most investors, hedge funds are restricted to accredited investors. Additionally, there are other barriers to entry with hedge funds, such as generally higher minimum initial investments than with mutual funds. By contrast many mutual funds have very low minimum investment requirements, some as low as $100. This will vary by the share class of the mutual fund and other factors.
- Mutual fund performance will often be highly correlated to the market benchmark or index that corresponds to its stated investment objective. For an index fund, this correlation should be quite high. It will vary a bit for actively managed funds. For hedge funds, part of the appeal is the fact that their strategy may not be highly correlated to the broad market. They should hold up better in a down market and may lag in an up market.
- Liquidity is a very different between hedge funds and mutual funds. With a mutual fund investors can sell shares one day and the sale will go trough at the close of trading that day as long as they have their trade in by the deadline for the fund. Hedge funds often restrict the ability of investors to access their money to set periods during the year. There may also be an initial lockup period of one year or more.