Hedge funds became a popular topic of conversation in 2021 as meme stocks surged and retail investors forced massive short squeezes to push these big-money funds out of their positions. As a result, several massive stock market players lost millions of dollars, while many retail investors cashed in.
Historically, hedge funds have been an interesting investment for those who are eligible to participate in them, often outpacing popular benchmarks by a wide margin. At first glance, they don’t look too much different from their distant cousins, mutual funds. But what exactly are the differences? And who should consider investing in one, the other, or a mix of the two?
Hedge Funds vs. Mutual Funds – Differences Between Them
At first glance, hedge funds and mutual funds seem like similar investment vehicles. They both pool money from a large group of investors, using the capital to make large-scale investments and create returns for their shareholders. They both provide relatively diversified portfolios and largely take the work out of the investors’ hands.
That’s where the similarities in these two types of investments stop, however.
As you dig deeper into the two types of funds, you’ll find that comparing them is like comparing apples to oranges.
|Hedge Funds||Mutual Funds|
|Returns||Believed to generate higher returns than widely accepted benchmarks.||Acceptable returns that are believed to be lower than hedge funds.|
|Risk||Higher risks due to the use of derivatives and unorthodox strategies.||Lower risk due to regulation, diversification, and reliable management.|
|Availability||Only available to accredited investors.||Widely available to institutional investors, retail investors, and accredited investors.|
|Management Fees||Higher management fees.||Lower management fees.|
|Liquidity||Lower liquidity.||Higher liquidity.|
|Management Style||Actively managed.||Actively or passively managed depending on the fund.|
Any time you invest in a fund managed by a third party, you’ll want to dive into the type of investment strategies it employs. When it comes to the hedge funds vs. mutual funds comparison, you’ll find that the two look at investing in very different ways. Here’s a breakdown of the investment strategies each uses.
Hedge Funds Investment Strategy
Hedge funds invest in a wide range of assets from land and real estate to stocks, derivatives, currencies, and more.
These funds are also known for taking part in aggressive, high-risk investing and trading practices like using derivatives and margin trading to achieve larger gains. For example, when the market is down or a company releases negative news, these funds may take part in short selling to profit as stock prices fall.
For hedge funds, the ultimate goal is to produce as much profit as possible, and accepting significant risks to do so is never off the table.
Mutual Funds Investment Strategy
Mutual funds are more straightforward and take advantage of safer investment strategies. The strategies mutual fund managers use are generally accepted to be low risk and employ heavy diversification. Some of the most common strategies used by mutual funds include:
- Indexing: Attempting to replicate the returns of a widely accepted stock market index or sector index.
- Value Investing: Investing in stocks that trade with lower valuations than their peers in hopes of benefiting from a strong recovery.
- Growth Investing: Investing in stocks that have a strong history of growth in revenue, earnings, and stock price.
- Income Investing: Investing in stocks that produce income through high dividend yields.
The management style of a fund is important for two reasons. First, investing styles that require more work to manage generally come with higher costs. Moreover, active management often comes with increased risks of human error that must be considered.
Hedge Funds Management Style
Hedge funds are actively managed, meaning that hedge fund managers, teams of traders, and analysts are constantly looking to pounce on new opportunities in and outside of the stock market.
These teams are known for taking an unorthodox and often risky approach to investing and fund management, often including the use of derivative investments and alternative investments in off-market assets like fine art, wine, and just about anything else that has the potential to grow in value.
Mutual Funds Management Style
Mutual funds can be either actively managed or passively managed. Here’s how the two options work:
- Actively Managed Funds. Actively managed mutual funds are managed by a professional fund manager, group of traders, and analysts. This team takes an active role, constantly researching and trading securities in an attempt to beat market benchmarks for their investors using the strategies outlined in their prospectus.
- Passively Managed Funds. Passively managed mutual funds, also commonly referred to as index funds or index mutual funds, seek to track the performance of an underlying benchmark. They do this by mimicking the makeup of the benchmark, such as by owning shares in all the companies listed on an index. Because this approach doesn’t require a professional fund manager to find and research new investment opportunities or manage day-to-day trading, these funds generally have lower expense ratios.
This is another area where these two types of investment funds vary wildly. Ultimately, mutual funds are far more accessible than hedge funds. Here’s why:
Eligible Investors for Hedge Funds
Hedge funds are considered to be private investment funds, which means in the U.S. they fall under Regulation D of the Securities Act of 1933. This regulation stipulates that private investments can only raise funds from accredited investors.
As a result, in order to invest in a hedge fund, you must meet one the following investment requirements:
- High Net Worth Individuals. You have a minimum net worth of $1 million or more.
- High Income Individuals. You’ve earned at least $200,000 per year over the past two years, and are expecting the same in the current year.
Eligible Investors for Mutual Funds
Mutual funds are designed for all types of investors. No matter what your net worth is or whether you’re a retail investor, institutional investor, or high net worth individual, these funds will accept your investment.
Different asset classes come with different levels of risk. You can expect to see the following asset classes included in each type of fund’s portfolios:
Hedge Fund Asset Classes
Hedge funds invest in a wide range of asset classes. They take part in traditional securities investments like stocks and bonds, but they also invest in land, real estate, currency, derivatives, and just about anything else.
Virtually any asset class is fair game for a hedge fund. If the fund manager believes the investment is going to produce a solid return, there’s no hesitation in making it.
Mutual Fund Asset Classes
Mutual funds are more traditional in the asset classes they invest in. Most only invest in market-traded securities like stocks and bonds. A few specialized mutual funds may use leverage or invest in alternative securities, but usually only in small amounts.
Liquidity is a term used to describe how easy it is to buy and sell shares of an investment. High liquidity investments are easy to buy, and they’re easy to sell when you determine it’s time to exit. With low liquidity investments, you may find it difficult to exit your position exactly when you want to.
Hedge Fund Liquidity
Hedge funds are not always liquid investments. In most cases, these funds come with lockup periods, meaning that once you invest, you’ll have to wait months or even years to access your money again.
Even if you’ve made it past a lockup period, hedge funds have the ability to lock liquidity for various reasons.
For example, if a bear market or high volatility event takes place, the fund manager may decide to lock redemption to protect investors from a widespread selloff in the portfolio. While that does act as a source of protection, it also greatly limits the liquidity associated with these investments.
Mutual Fund Liquidity
Mutual fund investors enjoy a much higher level of liquidity. In general, investors are able to pull their money out of an investment within a single trading day. While that offers little by way of protection from a large selloff in the fund, it also means that you’ll have easy access to your money when you need it.
Fees and Minimums
It’s important to pay attention to the fees you’re charged when you invest. Each fund comes with its own management fee, and high fees can cut deeply into your earnings. It’s also important to consider the minimum investment a fund requires to ensure you’re comfortable with the capital outlay necessary to get involved.
Hedge Fund Fees
Due to the highly active nature of hedge funds, and costs associated with the wide range of derivatives and other asset classes they use, hedge funds generally charge far higher fees than other investment-grade funds.
Like many mutual funds, hedge funds charge management fees that generally range between 1% and 3% of assets under management. But unlike other types of funds, hedge funds also tend to charge performance fees, which can range from 10% to 30% of the profits the fund creates. A common fee structure for hedge funds is a “2-and-20” arrangement — the hedge fund charges investors 2% annually and keeps 20% of the profits it makes above a certain benchmark.
So although hedge funds have a wide-open playbook and can generate some excellent returns, many advisors argue that the exorbitant fees these funds charge make investments in them less than worthwhile.
Minimum investments are often a turnoff as well. On the low end, these funds will come with $100,000 minimum requirements. On the high end, you may have to shell out $1 million to get involved.
Mutual Fund Fees
Mutual fund fees are generally easier to understand and manage. These funds display an expense ratio, which compares the annual cost associated with the fund to the amount invested. Most mutual funds charge an expense ratio ranging from 0.25% to 1.5%. So, if you have $10,000 invested, you’re paying between $25 and $150 in annual management fees to the fund.
The minimum investments mutual funds require are also significantly lower than hedge funds. In general, minimum requirements to get started in a mutual fund range from $1,000 to $5,000.
Everyday investors can get around even these modest fees and minimums by choosing exchange-traded funds (ETFs). Not only do these funds reduce the initial outlay required to get involved down to the price of a single share, ETF fees tend to be significantly lower than either of the options above. Some ETFs costs as little as 0.03%, or $3 annually per every $10,000 invested.
Any time you invest, performance must be taken into account. After all, you’re in the market to make money.
Here’s how the two types of funds stack up.
Hedge Fund Performance
It is generally believed by hedge fund investors that these funds produce high returns in relation to other investment options. This general belief has been proven by the data to be incorrect.
Look at the chart below that compares the returns of the S&P 500 to the HFRI Fund Weighted Composite Index, an index that tracks overall hedge fund returns:
|One-Year Returns||Three-Year Returns||Five-Year Returns|
|HFRI hedge fund index||11.13%||10.05%||7.64%|
(Data as of December 3, 2021)
As you can see, by all measures, over the past five years the S&P 500 has handily outpaced the average returns of hedge funds. That suggests hedge funds aren’t worth your time, but it’s important to keep in mind that the data above is based on averages. Some hedge funds do have a history of outpacing market averages, but they are few and far between.
Nonetheless, the search for strong-performance funds keeps many wealthy investors pouring into hedge funds, even as most individual funds underperform on average.
Mutual Fund Performance
Mutual funds, on the other hand, provide more realistic promises in terms of returns, and they generally keep them. For example, if a mutual fund outlines in its prospectus that it aims to replicate the results of the S&P 500, there’s a strong chance they will do so through their investments.
Many of these funds are designed to mimic the returns of the broader market. However, it is important to keep in mind that with actively managed funds, performance will be largely dependent on the team that’s managing the money.
Before diving into any fund, looking into its historic performance in relation to benchmarks you’re interested in meeting or beating is always a wise decision.
Regulation is a source of protection for investors. When a fund is heavily regulated, it must follow specific rules designed to protect investors, while underregulated funds don’t have to play by the same rulebook. Here’s how the two break down:
Regulation of Hedge Funds
The Securities and Exchange Commission is far less involved in private investments. Because that’s the category hedge funds fall into, regulation on them is minimal.
This lack of regulation is what makes it possible for hedge funds to take significant risks and invest in such a wide range of assets with their customers’ money. It’s also the reason these funds are only open to accredited investors.
Regulation of Mutual Funds
Mutual funds are heavily regulated and only invest in securities that are publicly traded, like stocks and bonds. The heavy regulation protects investors from significant losses due to unorthodox investment methods, outright fraud, and investments in questionable high-risk assets.
The Verdict: Should You Choose Hedge Funds or Mutual Funds?
This is the million-dollar question. Which type of fund should you choose? Here’s what you should consider:
You Should Invest in Hedge Funds If…
Hedge funds are rarely the best fit due to their high fees, high levels of risk, and lack of performance to show for it. However, there is one instance in which a hedge fund might be a better choice.
If you’re a high net worth individual who wants to live on the wild side and take a crapshoot at big gains, by all means, hedge funds are for you.
However, be sure to do extensive research on any hedge fund you might consider buying into. Remember, on average, hedge funds fail to meet the returns of the overall market, let alone beat them. You’ll be looking for a diamond in the rough here.
You Should Invest in Mutual Funds If…
In most situations, mutual funds are a better fit for investors. If you’re the average Joe and you don’t have hundreds of thousands or millions of dollars to throw around, mutual funds will be the best fit for your money.
Even if you have the wealth and accredited investors status to qualify to get involved in hedge funds, you may not want to. If you’re a fan of market-matching performance with limited risks, mutual funds are going to be the better option for you.
Both Are Great If…
In one rare instance, a mix of hedge funds and mutual funds may be just what you need.
If you’re an accredited investor with a reasonable tolerance for risk, but you want to limit the risk, consider diversifying between hedge funds and mutual funds.
Mutual funds will offer higher levels of stability while hedge funds will give you some high-risk, high-reward allocation.
All in all, there’s no real comparison between hedge funds and mutual funds. Historically, mutual funds have produced better returns, come with lower fees, and have been far more accessible to everyday investors than hedge funds.
Regardless of which option you choose, it’s important to do your research before diving into any investment. After all, you don’t want to risk your hard-earned money on something you know little to nothing about.