Index funds minimize risk by tracking a market metric, like the S&P 500 or a specific industry as a whole. Hedge funds maximize profits by taking high-risk positions and making investments that mitigate those risks. These are radically different investment vehicles. Here’s what you need to know. Consider working with a financial advisor who can help you decide which one, given your risk profile, time horizon and goals, makes the most sense for you.
What Are Index Funds and Hedge Funds?
Though both of these types of securities have the word “fund” in their titles, there are key differences, in structure, pricing and goals.
An index fund is a portfolio-based investment product. This means that the firm that runs the index fund buys a group of assets and operates them as an overall investment portfolio. The firm then sells shares in this portfolio. Investors buy these shares and collect returns in proportion to their overall ownership percentage of the portfolio. For example, say the firm issues 100 shares. Each share of the index fund would entitle you to 1% of the fund’s overall returns.
This asset is known as a “fund” because it builds its portfolio using the collected resources of its investors. As you buy into the index fund, the money you use to buy shares is used to grow the portfolio overall and continue making further investments.
Funds are one of the most common financial products on the market. The most common types are exchange traded-funds (ETFs) and mutual funds. Both are substantially similar and differ mainly in how their shares are held and traded.
An index fund is a subsection of portfolio-based investing. Most funds are built around a specific target or goal. For example, a mutual fund may be organized around maximizing short-term gains or minimizing overall risk. An index fund is built to track some third-party metric that the organizing firm considers valuable. It is literally “indexed” to this value.
Generally speaking, an index fund will track a major market indicator. For example, the most popular index funds track the S&P 500, the Dow Jones Industrial Average and the NASDAQ Composite. They will also frequently track major industries, such as the technology sector, or financial bellwethers such as Treasury interest rates.
An index fund will be built to track its index both up and down. This means that the fund is not organized to generate any specific gains. Nor is it organized to reflect the score of its current index, given that index scores are ambiguous values. Instead the fund aims to reflect the specific growth and losses of its related metric.
For example, at time of writing the NASDAQ Composite was at approximately 14,300 points. A relevant index fund would not target an overall value of $14,300 per share. Instead it would be built to increase and decrease generally in tandem with the NASDAQ market. If the NASDAQ Composite increases by 10%, this fund would aim to increase by 10% as well. If the NASDAQ Composite loses 5%, this fund would do so, too.
The goal of an index fund is to create stability by following long-term market metrics. The fund also tries to generate strong returns by building itself around a market sector that grows well in the long run.
A hedge fund uses the same pooled asset approach as an index fund. In both cases, this is an investment product put together by a firm out of a portfolio of assets. Traders can invest on a per-share basis and they collect returns proportional to the number of shares they own. The firm uses the funds that it collects from investors to grow the portfolio, ideally increasing the returns of this product reciprocally. However, that’s where the similarities end.
Hedge funds are high-risk products designed to seek the maximum possible return in any situation. Where index funds invest in standard securities (with an overwhelming emphasis on stocks and bonds), hedge funds can invest in virtually anything that has value. It is common for hedge funds to invest in real estate, precious metals, startup companies, emerging economies, art, collectibles and more. Essentially, if a hedge fund analyst thinks it can make a profit, the fund is free to invest accordingly. Market indexes and industry sectors do not necessarily guide hedge fund managers.
They also take far more aggressive positions when it comes to standard securities. A hedge fund is far more likely to pursue short positions, leveraged positions, low-credit bonds and other high-risk, high-reward investments.
A hedge fund takes its name from the fact that it generally builds the portfolio around countercyclical positions. This mitigates, or “hedges,” some of the risks that the fund takes. For example, if a hedge fund buys a series of stocks, called taking a long position in the stock market, it may also take a series of put options out on other stocks.
In addition to smoothing out risk, this approach gives the fund a way to profit even in a market downturn. This may seem at odds with the high-risk nature of these funds, however the fund’s countercyclical investing merely gives it the opportunity to profit in a wide variety of markets. At the end of the day, high-risk products always come with a serious chance of loss.
Why Invest in Index Funds vs. Hedge Funds?
The biggest difference between investing in an index fund vs. a hedge fund is who can make these investments.
Since hedge funds are such high-risk products, the Securities and Exchange Commission restricts them to what is called “accredited investors.” This means that only investors with high net worth (typically millions of dollars) or professional experience can invest in hedge funds. An ordinary household cannot do so. The idea behind this prohibition is that accredited investors know the risks involved with investing in hedge fund products. They will have the skill necessary to do their own research and to see behind any hard sell that the hedge fund might give. They also have enough money that they can afford to have an investment go bad.
Index funds do not have this restriction. A standard index fund is open to any investor on the market.
Index funds also tend to be much lower risk than hedge funds. While this varies based on the product you’re buying, index funds tend to follow large, long-term metrics. This gives them stability and pegs them to the market as a whole. In fact, as noted above, the most popular index funds do simply track the stock market overall.
Finally, an index fund is far cheaper than a hedge fund. On average, index funds charge between 1% and 2% in fees. Many charge far less, with some popular funds coming in below 0.05% in fees. By contrast, hedge funds generally charge 2% in fees plus an additional 20% of any profit on your investment.
It is hard to compare the outcome of investing in index funds against hedge funds because there is very little reliable data on hedge fund returns. Hedge funds are private entities, and so they don’t have to report their returns to the market as a whole. However, for the average investor the difference is moot. If you do not have the funds to meet the SEC’s standard of an accredited investor, you cannot buy this product. If you do meet this standard, then look carefully at the bottom line. Many index funds post returns of 7% to 10% and even higher.
That’s a tough number to beat.
The Bottom Line
An index fund is a portfolio of assets designed to track some specific segment of the market and takes its profits from overall market growth. A hedge fund is a portfolio of often exotic assets that seeks outsized returns in exchange for high risks and high costs. Hedge fund managers may use futures, options, real estate, commodities, currencies and a wide variety of derivatives such as delta neutral investing and collaterized debt obligations. Normally, they’re used by institutions and high-net-worth individuals.
- Are hedge funds a good fit for your portfolio? Will the mitigated position of index funds help you in the long run, or should you aim for higher growth? SmartAsset’s matching tool can connect you with a financial professional in your area to help you answer these questions and many more. If you’re ready, get started now.
- Knowledge is half the battle. Make sure you know what taxes you may have to pay on your investment returns with SmartAsset’s free capital gains calculator.
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