As investors accumulate wealth, many look to invest beyond traditional stocks and bonds. Investments through hedge funds and venture capital involve complex structures and higher risk, yet have the potential for outsized gains. Let’s compare the advantages and disadvantages of hedge funds vs. venture capital for your portfolio.
A financial advisor can help optimize your investments to minimize your tax liability.
What Is a Hedge Fund?
Investors pool their money in a hedge fund. Experts in their field manage hedge funds and focus on a specific niche or geographic region. Some hedge funds are unconstrained and, therefore, may invest in any opportunities they find. Hedge funds often use risky or complex investments, including leverage, to achieve outsized returns for investors.
Unlike index funds, hedge funds are actively managed. Due to the nature of its investments, investors must commit their money for a minimum number of years. Because of this, hedge funds are illiquid and investors should only use long-term money when they invest. Only accredited investors may invest in a hedge fund.
What Is Venture Capital?
Venture capital is a form of private equity that invests in startup companies that have the potential for long-term growth. These investments typically come from investment banks, wealthy investors, and other financial institutions. Venture capital investors not only invest in the company, but many also provide valuable advice, business connections, and other services to help the company grow. A representative of the venture capital investor often sits on the company’s board.
Many startups turn to venture capital investments because they are so new or they have not yet turned a profit. Banks and other lenders typically require an established track record and profitability to illustrate how the company can repay the loan. Venture capital investors understand that a company may fail, but stand to receive a significant payday if the company succeeds and goes public or another company acquires it.
Differences Between Hedge Fund vs. Venture Capital
While hedge funds and venture capital are investment options for accredited investors, each has distinct differences that you should be aware of.
- Active vs. passive investing. Hedge funds are run by investment professionals who research and choose companies to invest in. Investors seeking passive investments, choose hedge funds because its managers handle the day-to-day operations of the fund and its investments. Venture capitalists take an active approach and typically offer more to companies than a cash infusion.
- The number of companies invested in. Hedge funds usually invest in a number of companies, so when you put your money into a hedge fund, you’re buying a proportional share of its portfolio. As a venture capital investor, you invest in specific companies or projects, so you have less diversification.
- Age of the company. Venture capital investments typically target startups or young companies that need money to grow the business exponentially. Hedge funds usually focus on undervalued companies with an established track record.
- Types of investments. Venture capital invests in startups to accelerate their growth and generate high returns for investors. Hedge funds invest in a variety of investments, ranging from stocks, bonds, commodities, and others using complex structures, leverage, and more to boost returns.
Hedge Fund vs. Venture Capital: Which Is Best?
The best investment option between a hedge fund vs. venture capital depends on how active you want to be in your investments. A hedge fund offers active management that chooses investments for passive investing. Venture capital investors need to be more active in their investments. You need to select which deals that you’ll invest in, and you may invest time and expertise into the company as well for it to succeed.
In most cases, only accredited investors are eligible to invest in hedge funds and venture capital. Primarily, hedge funds focus on established companies, while venture capital helps startups mature into bigger companies. These investments are long-term in nature and usually involve much greater risk than the average stock or bond investment. In return for those high risks, investors have the potential for outsized gains when they are successful. When deciding between a hedge fund vs. venture capital, the best investment depends on what stage of a company’s life you want to invest in.
Tips for Investing Your Money
- Wealthy investors who want to diversify their portfolios should consider hedge funds, venture capital, and others. Knowing which investments are best for your portfolio can be a challenge, but a financial advisor can help you find the best investments to meet your goals. 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.
- Knowing your investment goals helps you decide how much risk to assume within your portfolio. SmartAsset’s investment calculator forecasts investment growth over time based on your inputs. Using your current balance, additional contributions, timeframe, and rates of return, it illustrates the potential size of your portfolio.
Photo credit: ©iStock.com/shapecharge, ©iStock.com/, ©iStock.com/Deagreez