A common question in the world of investment is: hedge fund vs mutual fund - what's the difference? On the face of it they're very similar because both work on the basis of investors creating a pool of funds and placing that pool under the control of a fund manager. The manager is responsible for choosing where and how the funds are invested, in order to generate returns on behalf of the investor. Every fund has its own investment strategy, which includes an element of diversification.
In short, both hedge funds and mutual funds are managed portfolios. However, this apparent similarity is misleading. There are significant differences between these two types of fund, and these differences are outlined below.
Those investing in mutual funds range from small-scale retail investors to large institutions such as insurance houses and sovereign wealth funds.
Mutual funds are attractive to these investors because they aim to provide a greater return than an investor could achieve by saving their money and earning an interest rate.
Mutual funds also have low investment barriers to entry - the minimum amount required to invest in a mutual fund is often very little.
In contrast, a hedge fund is open only to accredited investors. These are individuals with high net worth, that is, they have substantial income or savings. Alternatively, accredited investors are institutions with considerable investment expertise. These include pension funds, university endowments, foundations and insurance companies.
In addition to being open only to accredited investors, hedge funds require a substantial minimum investment, measured in hundreds of thousands of dollars or pounds.
Because they attract small-scale retail investors, a mutual fund will have many more participants than a hedge fund.
Both hedge funds and mutual funds seek to achieve a target return for their investors.
However, hedge funds are subject to less regulatory oversight and therefore have much more freedom in the way they generate return. The most common example of this is shorting - the practice of betting against certain financial securities. Hedge funds also have the ability to lever their investments - i.e. borrow additional capital to enhance the size of their trading position. Leveraging has the effect of increasing both the gains and losses resulting from any trade.
On the other hand, mutual funds are subject to far more regulatory oversight, and cannot short any securities or lever their positions.
This means that the types of returns each fund provides to an investor are often very different. A mutual fund's returns often have a similar profile to the market, because they cannot short in order to take positions against the market. A hedge fund on the other hand has much more scope to provide returns which are uncorrelated to the market, therefore 'hedging' an investor's portfolio if they are already heavily invested in the market.
Those putting money into either of these types of fund have little control over how that money is invested. The investment decisions are left to the fund manager and their team.
Hedge funds and mutual funds are both actively managed - meaning that in both cases the fund's investment decisions are made by the fund manager and their team.
Investors can also choose to invest in passive funds, such as Exchange Traded Funds ('ETFs'), which simply track the performance of a target index such as the S&P 500 or FTSE 100.
The forms of investment available to managers of both forms of fund include:
Mutual funds have a specific focus and will specialise by asset types or by region. This is defined in the prospectus they are required to issue, which sets out the strategies they will adopt. While this strategy gives investors confidence in how the fund will be operated, it also means their performance is restricted to what's occurring within that particular market or section of the economy.
Likewise, hedge funds will typically have a particular focus. However, the hedge fund manager has much more discretion over which assets to invest in and their strategies for that investment. They are continually looking across the financial markets for information and opportunities to maximise performance on behalf of their customer, the investor.
Investors of mutual funds are able to sell their holdings whenever they choose, converting their investment into cash. Mutual funds must be managed in such a way that this is possible and as a result, the fund must comply with a substantial body of regulation. Every day a net asset value or NAV is calculated for the fund, which is the price at which the investor is able to withdraw their funds.
Hedge funds, on the other hand, are not obliged to have funds available daily, in case investors want to make an exit. Investors can only choose to withdraw from the fund at specified points in time, which could be quarterly or even less frequently.
Mutual funds are usually set up as corporations, structures that reflect the high level of regulation governing their operations. This regulation helps to protect the interests of the retail investors, who have little knowledge of how the markets work.
Hedge funds are partnerships between the hedge fund manager and the investors. The fund manager typically has a significant investment in their own fund. Their method of operation, and their being open only to accredited investors, means they are subject to much less regulation.
The regulation comes from various bodies, such as the US Securities and Exchange Commission.
All managed funds involve fees, which cover the costs of operating the fund. The fees for mutual funds are much less than those for hedge funds.
A typical mutual fund charges a management fee, usually between 0.5% and 5% of the value of the assets in the fund. The level of fee represents the volume of management activity required for that fund.
The fees for hedge funds are higher. They are also calculated differently, with a management fee element of, say 2% of the assets being managed, topped by a charge based on the percentage of profits. This charge, known as 'carried interest' or 'carry', can be around 20% or even more.
The higher fees for hedge funds are often justified by the fact that a hedge fund is offering access to returns that are less correlated to the market, and thus providing investors diversified returns. Of course, this is not always the case and investors should always ensure they complete their due diligence before investing in any fund.
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