Stock Market Guide: Difference between mutual funds and hedge funds

As a different investment alternative, hedge funds have increasingly attracted investor’s interest in recent years, mainly because of their high return rates. For investors with a large amount of capital, hedge funds are a popular option.

What is a hedge fund?

A hedge fund is an investment capital pool that a manager invests on behalf of shareholders. In this basic operation, a hedge fund is similar to a mutual fund, but with a crucial difference: the total discretion it gives the fund manager when choosing to invest where and how. This means that hedge funds can hold any and all types of investments, from safer treasury bonds to riskier securities, stock options and future contracts.

Aggressively managed, hedge funds adopt bolder strategies than traditional funds. They may take speculative positions in derivative securities, such as options, short sell stocks and anything that can increase the fund’s leverage.

Mutual funds

Mutual funds cannot take such leveraged positions and don’t involve the same level of risk. The fund manager uses the fund pool to invest in a diverse basket of securities in the capital market, such as stocks, bonds and other tradable.

Contrary to hedge funds, they are available to any investor with minimal amounts of money. Even though some come with minimum investment requirements that range from $250 to $3,000, in fact you can even compare up to $1 million or more, which is required by big successful hedge funds.

Mutual funds give investors the opportunity to make a diversified and professionally managed basket of securities at a comparatively low cost, while the limit to use high-risk investments makes them better suited for the mass investing public.

The main difference between the two investment paths is that while mutual funds seek relative returns, hedge funds seek absolute returns.

Purpose of a hedge fund

A hedge fund aims to achieve higher returns than other investment vehicles. Thus, the freedom to invest in different assets and strategies turns out to be a great advantage, as the fund is free to seek maximum return for its clients. In other words, investments in a hedge fund can range from day trading with equities, investment in private securities, options, swaps, commodity arbitrage and even real estate acquisition.

Hedge funds may also use tools as leverage, short selling, asset leasing and other structured operations. Because they have higher returns, the management of these funds is carried out by highly specialized managers, who usually focus on volatile and complex operations in the market.

Motivated to pursue more significant gains, hedge funds often expose themselves to greater than normal risks. However, a hedge fund also adopts risk mitigation and diversification strategies.

Measures to protect the fund

While mutual fund investors can redeem their units on any given business day, hedge funds tend to be less liquid. Some offer weekly or monthly redemptions, while others offer quarterly or annually.  During periods of market volatility, hedge funds may suspend redemptions entirely in order to protect investors from a potential fire sale of the fund’s portfolio.

Who can invest in a hedge fund?

Due to their special character, hedge funds require a higher initial investment than usual. In some cases, this type of fund is restricted to high-income clients only, as typical minimum investment is between $500,000 and $1 million. Most of the big successful funds have even a much higher minimum initial investment.

In addition, this type of fund is usually closed exclusively to invited investors, not allowing new shareholders to enter. These accredited investors are deemed to have advanced knowledge of the financial market, investing with higher risk tolerance than standard investors. Managers are legally allowed to accept investments from up to 35 people who aren’t accredited investors.

Main differences between hedge funds and mutual funds

  • A hedge fund is a portfolio investment whereby only a few accredited investors are allowed to raise their money to buy assets. Mutual funds refer to a professionally managed investment vehicle, where funds are collected from various investors to buy stocks and bonds.
  • Hedge funds seek absolute returns, while mutual funds seek relative returns on investment in securities.
  • Hedge funds are aggressively managed. Advanced investment and risk management techniques are used to achieve optimal returns, which is not the case with mutual funds.
  • The owners of a mutual fund are in large numbers, even thousands of them, while hedge fund owners are limited in number.
  • Hedge funds are lightly regulated, while mutual funds are strictly regulated by the Securities and Exchange Commission.
  • Hedge fund investors are high net worth investors, while a mutual fund has small and retail investors.
  • Management fees depend on the percentage of assets managed in mutual funds, while hedge funds fees are based on asset performance. Mutual fund operational fees range from 0.05% to 5% or more. Hedge funds typically include a management fee of 2% and a performance fee of 20%.
  • In mutual funds, reports are published annually and disclosure of asset performance is made every six months. With hedge funds, information is provided only to investors and there is no public disclosure of transactions.

Conclusion

If you want to invest in one of these two funds, you can make a choice according to your resources. If you have a large amount of money, you can opt for hedge funds, while if the value of your investment is low, then opt for mutual funds.