Both hedge funds and mutual funds are investment products offering managed portfolios for investors, but that's about where the similarities end. Hedge funds target high-net-worth individuals and take on more complex and volatile trading strategies in an effort to produce positive returns for clients. Mutual funds are available to any investor, but they're more restricted in what they can trade. The main goal of a mutual fund manager is to outperform a benchmark index.
Major takeaways
Mutual funds:
- Pool money from all investors with minimum investments as low as $1.
- Regulated by the U.S. Securities and Exchange Commission (SEC).
- Available for trading every day the stock market is open.
- Usually buy and hold securities based on a specified strategy detailed in a prospectus.
- Charge a flat fee as a percentage of assets under management.
Hedge funds:
- Pool money from accredited investors with a liquid net worth above $1 million or an annual income exceeding $200,000.
- Structured as general partnerships and not heavily regulated by the SEC.
- Limited windows to invest and withdraw funds.
- Use trading strategies including derivatives, shorting, and buying alternative assets.
- Charge fees based on performance as well as assets under management.
What are mutual funds?
A mutual fund is an easy way for individual investors to gain access to a managed portfolio of publicly traded securities such as stocks and bonds. Investors buy shares of a mutual fund, and their money gets pooled with other shareholders by the fund manager. The manager works to meet the objectives laid out in the prospectus, which will detail the benchmark index the manager's performance should be weighed against and the strategy they'll use to invest.
Investment strategies
Mutual funds are generally considered safer investments than hedge funds. That's because fund managers are limited in their ability to use riskier strategies such as leveraging their holdings, which can increase returns, but it also increases volatility.
Mutual funds buy publicly traded securities based on the manager's criteria. Those criteria could be very specific like buying pharmaceutical stocks the manager thinks are undervalued based on certain metrics, or they could be very general like simply buying every stock in the S&P 500 index. There's a wide range of strategies available to mutual fund investors, and the details are laid out for investors in the prospectus.
Types of mutual funds
There are a few different types of mutual funds investors should be aware of.
- Actively managed vs. passive funds. Actively managed mutual funds are characterized by a fund manager who attempts to beat the fund's benchmark index by strategically buying and selling securities. Passive funds, or index funds, merely try to replicate the returns of the benchmark index by modeling a portfolio based on the index. Sometimes, the fund will just buy every security in the index.
- Open-ended vs. closed-ended funds. Open-ended funds have no limit to the number of shares they can issue. Investors simply buy shares, and the fund manager takes new inflows and allocates them to the appropriate securities. Closed-ended funds have a limited number of shares, so the portfolio manager doesn't have to deal with inflows or outflows. In order to buy or sell shares, you have to find a buyer or seller on the open market.
- Load vs. no-load funds. Funds with a load pay a commission to the broker who sells the investor the fund. The commission comes out of the investor's funds either at purchase (front-loaded) or at the sale of the mutual fund (back-loaded). No-load funds do not have such a commission.
Who can invest?
Mutual funds are available to every investor. Some funds may have a minimum investment ranging from $100 to $10,000 or more. More and more funds have no minimum investment these days.
How mutual fund fees work
Mutual funds charge a management fee, which typically ranges between 1% and 2% of assets under management. Index funds usually have much lower fees. Some broad-based index funds have fees close to 0%.
Note that the management fee is separate from the fees paid in loaded funds where the broker receives some of the investors' funds as well. The management fee goes directly to the mutual fund company, and it's paid annually.
How are mutual funds regulated?
Mutual funds must register with the SEC in order to sell shares publicly. The SEC enforces several regulations, including the Securities Act of 1933, which requires mutual funds to provide investors with certain information, including a description of the fund, information about management, and financial statements. The Investment Company Act of 1940 also requires mutual funds to provide details of their financial health and investment policies.
What are hedge funds?
A hedge fund is designed as a way for individual investors to gain access to the investment ideas and strategies of fund managers they believe have an edge on the market. Hedge funds are structured as general partnerships, and investors buy into the investment company directly as limited partners instead of buying publicly offered shares.
Investment strategies
Hedge funds aren't limited in the strategies they can use in order to produce positive and outsized returns for their investors. Hedge funds will use derivatives such as options and margin to gain leverage, and they may sell stocks short.
Hedge funds are also able to invest in just about any market: cryptocurrency, private real estate, or vintage single malt scotch. These are strategies unavailable in mutual funds due to SEC regulations. They're also much riskier strategies than simply buying publicly traded securities.
Who can invest?
Hedge funds are only able to accept funds from accredited investors. The SEC defines an accredited investor as someone with a liquid net worth (home equity doesn't count) of $1 million or an annual income of $200,000 (or $300,000 with a spouse). The SEC believes that level of wealth makes an investor more sophisticated and better able to withstand the volatility and uncertainty associated with hedge funds.
Hedge funds often have minimum investments of $1 million or more. They typically limit investment windows, and they can have minimum holding periods. They can also restrict when investors can withdraw. As such, hedge fund investors require a good amount of liquidity outside of their investment in the hedge fund.
How hedge fund fees work
Hedge funds charge two types of fees: management fees and performance fees. A management fee is similar to the management fee for a mutual fund. The fund charges an expense ratio, typically 2%, that's taken out of the assets under management every year.
The performance fee, as the name implies, is based on the fund's performance, and it's usually 20% of the gains. So, if the fund increases by 10% one year, the fund takes 20% of the gains (2% of the investment), and the rest stays invested with the fund. If the fund loses money, there's no performance fee, but the investors still have to pay the management fee.
The most typical fee structure — a 2% management fee and a 20% performance fee — is known as 2-and-20.
How are hedge funds regulated?
Hedge funds only have to register with the SEC once they reach total assets under management of above $100 million. Beyond that, they must abide by Regulation D of the Securities Act of 1933 and limit their investors to accredited investors. That allows them to remain exempt from most reporting to the SEC and makes investing in a hedge fund much more opaque than investing in a mutual fund.
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Additional considerations
Hedge funds have shown worsening performance over the past 15 years or so even as the U.S. stock market has been on a tear. In fact, in bull markets, mutual funds may provide better returns than hedge funds net of fees since alternative investment strategies fail to keep up with the stock market.
That said, those strategies can be invaluable in bear markets. If the strategies have returns truly uncorrelated with U.S. stocks, they could provide positive returns as the stock market craters. That's when a hedge fund will really live up to its name.
While hedge funds hold the promise of big returns supported by advanced trading strategies, they can go for long periods without producing the expected results. For patient investors, they could pay off.
But perhaps the age when hedge funds could outperform the average investor is over. Today's technology makes it easier for retail investors to invest and use their own strategies, whether they're exceedingly simple or super complex. For most investors, a mutual fund will be able to meet all of their investing needs, but they're a bit more boring than hedge funds. But good investing is usually boring.
