Hedge funds and mutual funds are both popular investment vehicles, but they cater to different types of investors and have distinct characteristics. Hedge funds typically involve higher risk strategies, use leverage and are open only to accredited investors willing to commit significant capital. Mutual funds, on the other hand, are designed for the general public, allowing everyday investors to pool their money together for diversified investments managed by professionals. The key differences between hedge funds vs. mutual funds revolve around accessibility, investment strategies, risk profiles and regulatory oversight.
A financial advisor can help you create a financial plan for your investing needs and goals.
What Is a Mutual Fund?
Buying an individual security may take time, expertise and research. Additionally, you may have to work to find the right stocks that can make up a balanced portfolio and minimize your risk. Even after all that, this strategy may not help you meet your financial goals and objectives.
This is where mutual funds come in. Mutual funds remove the need to research your stock and bond selections. You can simply purchase a mutual fund from a fund company, and they will buy shares and bonds for you. Essentially, the investor chooses the fund company or fund instead of the securities that make up the fund.
Mutual funds may hold a mix of domestic and international stocks and bonds. They may also specialize in a certain sector of the market such as real estate. Or, an investor can invest in a target-date fund that holds a mix of stocks and bonds that rebalance along an investor’s schedule
What Is a Hedge Fund?
A hedge fund is an investment vehicle that gathers capital from multiple investors and uses various, often sophisticated strategies to achieve significant returns, generally independent of typical market movements. Hedge funds are generally limited to accredited investors, meaning participation is restricted to those with substantial wealth or income.
Unlike conventional investment funds, hedge funds operate with fewer regulatory constraints, giving fund managers more freedom in their investment tactics.
Hedge funds may use strategies such as leverage, derivatives and short selling to maximize gains and manage risk. They can invest in a wide variety of assets, including stocks, bonds, commodities, and even private companies.
This broad range of investment tactics aims to achieve high returns, but it also comes with a higher risk compared to other types of investment funds.
Hedge Funds vs. Mutual Funds: Similarities
Despite their many differences, mutual funds and hedge funds share some key similarities, particularly in how they are structured and their overall objectives.
Pooled Investment Vehicles
Both mutual funds and hedge funds serve as pooled investment vehicles, which means they collect money from multiple investors to create a larger, managed portfolio. This structure allows individual investors to benefit from professional management and the advantages of investing at scale without having to directly handle the buying or selling of individual assets.
Diversification
Also, they both offer diversification because they invest in different types of asset classes. However, this depends solely on the fund. Some funds are highly concentrated in a certain sector of the economy or asset class. Usually, hedge funds are diversified into certain security types such as commodities or stocks, whereas mutual funds commonly have a specific focus and may invest in on security type.
Professional Management
Lastly, when investors select a mutual fund or hedge fund, they are selecting the fund manager instead of the securities within the fund. Essentially, investors may select a fund that coincides with their investment philosophy. Most hedge funds are usually actively managed, which means the manager or management company uses their analytics, expertise, and knowledge to select securities and the time at which they are purchased.
Mutual funds can either be actively managed or passively managed depending on their objective. If they are passively managed, the fund manager select assets to hold them for an extended amount of time to reach the benchmark of the index.
Hedge Funds vs. Mutual Funds: Differences
Hedge funds and mutual funds differ significantly in their structure, strategies, and the type of investors they attract. Understanding these differences can help investors choose the right option based on their risk tolerance, current wealth and investment knowledge.
Investor Access and Requirements
One of the most notable differences between hedge funds and mutual funds lies in investor access. Hedge funds are open only to accredited investors—those meeting specific income or net worth criteria. This exclusivity allows hedge funds to engage in riskier investment strategies. In contrast, mutual funds are designed for the general public, allowing individuals with smaller amounts of capital to invest and access professional management.
Investment Strategies
Hedge funds use a wide variety of aggressive strategies to generate high returns, including leverage, derivatives, and short selling. They often aim to deliver absolute returns, regardless of market conditions. Mutual funds, on the other hand, focus on long-term growth through diversified investments in stocks, bonds, or other securities. These funds are typically more regulated, meaning they tend to avoid high-risk strategies and instead prioritize consistent, steady returns over time.
Regulation and Transparency
Mutual funds are heavily regulated by the Securities and Exchange Commission (SEC) to ensure transparency and investor protection. They provide regular disclosures regarding their holdings, strategy, and performance. Hedge funds face significantly less regulatory oversight, allowing them more freedom to operate and make quick investment decisions. However, this reduced oversight also means less transparency for investors.
Risk and Return Profile
The potential risk and return differ considerably between hedge funds and mutual funds. Hedge funds seek higher returns using aggressive tactics, which inherently increases the level of risk, including the possibility of substantial losses. Mutual funds are generally considered safer, as they emphasize diversification and lower-risk strategies, making them suitable for a wider range of investors.
Fees
Hedge funds are known for their “2 and 20” fee model, which includes both management and performance fees. Mutual funds typically have lower fees, which may include a flat management fee or expense ratio, making them more cost-effective for average investors.
Additional Considerations
The objective and performance of mutual funds versus hedge funds is generally another differentiator. Hedge funds often yield high returns in any economic environment including a recession or market downturn. Since many hedge funds take a more defensive approach, returns may not be as high as some mutual funds during a bull market.
During a bull market, a hedge fund may only see a single-digit returns, while a mutual fund may see returns in the double digits in a recession. In a bear market, a mutual fund may still see a positive return while a hedge fund may have a negative one.
Bottom Line
The biggest gain of investing in a hedge fund is its potential to yield stable returns and keeping pace with inflation while minimizing the investor’s exposure to risk. However, many average investors may not meet the minimum net worth and investment requirement to participate in the fund.
Therefore, the average investor may be better off investing in a mutual fund with a diverse portfolio. Mutual funds are accessible to most investors and more affordable. Therefore, investing in mutual funds may be a better investment strategy for achieving long-term returns for the average investor. If you’re unsure of which investments make sense for your financial objectives it’s wise to partner with a financial advisor. A financial advisor can help you identify the best investment selections that will help you achieve your financial goals.
Tips for Investing
- If you don’t have a lot to invest, you might want to consider a robo-advisor. Robo-advisors, which are entirely online, offer lower fees and account minimums than traditional financial advisors.
- If you have a more complex financial situation or just prefer talking face-to-face, consider working with a traditional financial advisor. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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