If you are an ordinary investor, an ETF is often a good investment. In part this is because an ETF has a more stable risk profile than a hedge fund, but mostly it’s because an ETF is your only legal option. Hedge funds are limited to institutions and high-net-worth (or “accredited”) investors. If you are an accredited investor or an institution, choosing whether to invest in an ETF or a hedge fund is a question of goals. An ETF will generally provide you with more stability while a hedge fund is the choice for higher-risk/higher-reward investing.
For more help with choosing the right investments for you, consider working with a financial advisor.
What Is an ETF?
An ETF, or “exchange-traded fund,” is a form of portfolio investing. These assets have become very popular in recent years as an alternative to traditional mutual fund investments.
Like all portfolio-based produces, an ETF is built out of a series of underlying assets. Any given fund will trade a collection of publicly available products like stocks, bonds and commodities. The portfolio’s returns will be based on the collected gains and losses in those underlying assets. Individual investors, in turn, buy shares of the portfolio and get returns based on their proportional ownership of the portfolio.
Unlike more traditional assets, like a mutual fund, the key element of an ETF is liquidity. These funds are traded on ordinary stock exchanges (hence the name “exchange-traded fund). As a result, you can buy and sell shares in an ETF with no restrictions, the same way you could do an ordinary equity. This is different from more portfolio-based assets, which tend to have restrictions on how you can trade them. This liquidity has made ETFs a very popular option for many investors.
What Is a Hedge Fund?
A hedge fund is also a portfolio-based investment, but it works differently from an ETF in several key ways.
Hedge funds generally hold fewer assets and are more actively managed than ETFs. This means that usually a firm will spend far more time analyzing, buying and selling the underlying assets in a hedge fund than they will in an ETF. This is because the goal of a hedge fund is to seek outsized returns relative to the market. Hedge fund managers try to find investments that they think will do particularly well, and they’re willing to accept more risk than usual to achieve that.
Historically hedge funds were named after the process of mitigating, or “hedging,” that elevated risk. Modern hedge funds, however, are more known for their aggressive strategies than their offsetting investments.
A hedge can invest in virtually anything that it thinks will make money, although most are organized around specific areas of investment. For example, it’s unlikely that a technology-focused hedge fund would pursue a real estate investment. This includes private and unregulated assets, ones which are not available on the public market.
This range of options means that hedge funds can pursue riskier, potentially more lucrative, investments, but it also means that hedge fund investing is restricted to accredited and institutional investors.
ETF vs. Hedge Funds
Exchange-traded funds and hedge funds overlap in many ways, but ultimately these are extremely different products. Some of the most important points of comparison are:
Both Are Portfolio-Based Assets
This is probably the biggest area where these products overlap. Both hedge funds and ETFs work by investing in a series of assets, then profiting based on the average returns of the portfolio’s holdings. This makes both asset classes potentially more stable than investing in single, individual assets. For example a hedge fund might invest in startup companies, which would be more stable for individual investors than investing into a single startup directly.
ETFs Usually Use Index Strategies
Most exchange-traded funds are built around indexing a particular investment or area of the market. For example, you might invest in an ETF that tries to index itself to the technology sector, the real estate market or the S&P 500. This is not a hard and fast rule, but it describes most of these assets.
This makes ETFs generally a more stable asset class for investors, especially those seeking to balance risk and reward.
Hedge Funds Take Riskier Positions
Hedge funds are virtually always built to try and maximize return. A hedge fund’s team tries to actively manage the portfolio by trading assets in and out, and their goal is to provide a higher return than the market at large.
To do this, hedge funds generally invest in riskier products than ETFs do. This can mean many different things. In some cases a hedge fund will simply buy more speculative assets, like gambling on a riskier stock. In other cases, a hedge fund will buy into riskier positions or asset classes altogether, like investing in a startup company or real estate.
This makes hedge funds a better choice for investors looking to pursue a high risk/high reward strategy.
Hedge Funds Are Only for Accredited Investors
Ordinary investors can purchase ETFs, but they cannot invest in hedge funds. The reason for this is the asset classes behind each portfolio. An ETF can only hold standard, publicly traded and regulated assets in its portfolio. It also must obey liquidity requirements to ensure that investors can trade in and out without destroying the portfolio’s value.
A hedge fund, on the other hand, is free to pursue whatever obscure, risky or exotic investments that its managers feel worthwhile. The goal is to maximize profit and everyone involved accepts a higher degree of risk as the tradeoff. However this also means that a hedge fund can include lightly regulated assets restricted to accredited or institutional investors, meaning that hedge funds as a category are off limits unless you fit that description.
Hedge Fund Fees Are Generally Higher
Finally, hedge funds tend to charge significantly higher management fees than ETFs do. This is usually because a hedge fund is much more actively managed, while a firm will generally automatically manage an ETF through a series of pre-programmed rules and trading targets. It is also because hedge funds advertise outsized returns in exchange for outsized fees.
Investors trying to choose between hedge funds and ETFs should decide whether they’re looking to maximize potential returns or stability. A hedge fund can provide high returns, but with higher risk. An ETF will generally provide lower, more predictable returns but with a much lower risk profile.
The Bottom Line
A hedge fund offers an outsized risk/return profile, although they are restricted to institutions and accredited investors. An ETF is available to all investors and typically tracks a specific industry or index.
Investing Tips
- Exchange-traded funds are like mutual funds, but rather than simply putting money into a pool, you buy shares on a stock exchange.
- A financial advisor can help you figure out exactly which investments are best for you. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one 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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