What's the difference between a mutual fund and a hedge fund?
These two types of investment products have their similarities and differences.
First, the similarities:
Both mutual funds and hedge funds are managed portfolios. This means that a manager (or a group of managers) picks securities that he or she feels will perform well and groups them into a single portfolio. Portions of the fund are then sold to investors who can participate in the gains/losses of the holdings. The main advantage to investors is that they get instant diversification and professional management of their money.
Now, the differences:
Hedge funds are managed much more aggressively than their mutual fund counterparts. They are able to take speculative positions in derivative securities such as options and have the ability to short sell stocks. This will typically increase the leverage - and thus the risk - of the fund. This also means that it's possible for hedge funds to make money when the market is falling. Mutual funds, on the other hand, are not permitted to take these highly leveraged positions and are typically safer as a result.
Another key difference between these two types of funds is their availability. Hedge funds are only available to a specific group of sophisticated investors with high net worth. The U.S. government deems them as "accredited investors", and the criteria for becoming one are lengthy and restrictive. This isn't the case for mutual funds, which are very easy to purchase with minimal amounts of money.
Mutual funds allow you to invest in a basket of publicly traded securities run by an investment manager. In some rare cases they can own private placements in illiquid companies, but for the most part, they are responsible for selecting publicly traded securities, stock, bonds, etc. You can very easily buy mutual funds in a brokerage or retirement account. Fees are usually around 1%.
Hedge funds are private investment companies for accredited ($1M+ net worth) investors. Hedge funds can own anything, public securities, private securities, mines in Chile, real estate, even bitcoins, etc. You can't buy into a hedge fund via a brokerage or retirement account and most won't accept an investment of less than $250,000 to start. Most hedge funds are short term profit focused which can cause large tax bills for individual investors, when all of the gains are short term capital gains, personal tax rates are much higher. Hedge funds can be much better for institutional investors because they don't have to pay short term capital gains taxes. Fees are usually 2% on assets and 20% of performance.
Both mutual funds and hedge fund are professionally managed investment vehicles, but there are a couple major differences. Just about any investor has access to mutual funds. They’re diversified, easy to buy and easy to sell. Hedge funds on the other hand are only open to accredited investors who have a net worth of at least a million dollars or an income of at least $200,000 over the last 2 years. Hedge funds often have lock up periods, where for a period of time you cannot get your money out of the fund due to their propriety trading methodology that often involves leveraging.
Although not always the case, hedge fund fees are usually much higher than that of mutual funds. The typical two and twenty fee represents the 2% fee on assets under management and the additional 20% of fund profits, which goes to the hedge fund.
The similarity of mutual funds and hedge funds is that both invest in variety of securities (stocks, bonds, commodities, etc.). Either fund, whether a mutual or hedge fund, may be more risky than others. Before investing in either mutual funds or hedge funds, be sure you understand each of their investment goals/objectives and the potential downsides.
Mutual funds are registered with the U.S. Securities and Exchange Commission (SEC) and must make periodic reports of their activities. They are subject to reporting rules and government oversight. Mutual funds trade at the close of the market day at their closing net asset value (NAV) and are manged daily making buy and sell transactions with no market leverage. They invest in all types of investments, such stocks, bonds, commodities, REITs, etc.
Whereas hedge funds may appear to be similar to mutual funds but can be very different:
- The term hedge may be a misnomer. The term hedge fund commonly refers to a private investment fund that may invest its capital in a variety of markets using a wide range of investment strategies. Some hedge fund managers will hedge out certain market exposure in their portfolio while some managers will chose not to.
- Hedge funds may or may not be aggressive and risky strategies. There are thousands of hedge funds in the world that use dozens of strategies. The expected volatility of a hedge fund manager’s return is a function of their chosen strategy/investment objectives and their skill or track record/experience. Investing in private equity, small capitalization companies, emerging market stocks and/or using leverage are some hedge fund's strategies that may have more exposure to risk.
- Another difference between hedge funds and mutual funds are the terms of when investors can and cannot redeem their units. Mutual fund investors can instruct a redemption on any given business day and receive the NAV (net asset value). Whereas some hedge funds offer weekly liquidity, some offer monthly, while others only allow redemptions quarterly or annually. Many hedge funds impose a lock-up period (a portion of time you must leave your money in the fund without the ability to redeem). During periods of market volatility such as the most recent financial crisis, several hedge funds actually suspended redemptions entirely in order to protect the remaining investors from a potential fire sale of the fund’s portfolio. It is important to carefully read the hedge fund’s offering memorandum to fully understand your redemption rights.
Mutual funds are units, or shares, that can typically be purchased or redeemed as needed at the fund's current net asset value (NAV) per share. A fund's NAV is derived by totaling the assets in the portfolio minus any liabilities, then dividing by the total amount of shares outstanding. Mutual Funds usually invest in stocks of publicly traded companies. Most investors can invest in a Mutual Fund. Mutual Funds are liquid and can be sold or bought at the end of the day. Mutual Funds do not charge a performance fee. They are highly regulated investment vehicles.
Hedge funds are more difficult to define and the value of the assets can be more difficult to calculate. They were originally developed to invest in assets that provided a hedge to the general stock market. Hedge funds have become so diverse over the years that they can invest in commodities, currencies, interest rates, futures, derivatives etc. Therefore, Hedge Funds are no longer a uniform asset class. The common denominator is not the investment strategy, but the search for absolute returns. Hedge Funds are for accredited investors. They can have lock up periods and can have specific times when they allow new investments. Hedge Funds charge a performance fee. They are more loosely regulated than mutual funds.