Hedge funds and mutual funds seem to confuse investors. Usually, rich investors favor hedge funds, while all different types of investors use mutual funds. Understanding a hedge fund vs mutual fund can help investors select the best option for their portfolio. Here’s how you’ll know which is right for you.
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 a partnership of investors that usually use high-risk investment strategies to yield high rates of returns. Hedge funds use a variety of assets such as stocks, real estate and options to achieve their ideal investment strategy. Typically, hedge funds look for high net worth individuals or institutional investors to gain access to a lot of capital.
After investors or limited partners contribute to the fund, the investment manager will then determine the best investment method to yield the highest return.
Hedge Fund vs Mutual Fund Similarities
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.
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 Fund vs Mutual Fund Differences
Certain hedge funds and mutual funds have various limitations on who can invest. For example, some hedge funds may require the investors to have a $5 million net worth. Or, perhaps they require the investor to make a high initial investment to participate in the fund. On the other hand, mutual funds may only require a minimum initial investment and won’t look at the investor’s net worth.
The cost of investing in each fund also differs. Hedge funds usually have higher expenses than mutual funds. This is because hedge funds may charge an expense ratio as well as a performance fee. For example, there are often “two and twenty” hedge fund fees. This means they have a 2% expense ratio and charge a 20% cut of the profit generated by the fund. Because high net worth individuals tend to invest in hedge funds, they typically can charge whatever they want as long as they disclose the fee structure. Mutual funds may have a 1% or less expense ratio making it a more affordable option for the average investor.
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.
The 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 have a more complex financial situation or just prefer talking face-to-face, consider working with a traditional financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- 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.
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