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In this article we will go over the difference between hedge fund vs mutual fund to help you decide which is the best investment option for.
Mutual funds and hedge funds are both financial vehicles that offer managed portfolios to investors, but that is where the similarities end.
Hedge funds target high-net-worth individuals and engage in more complex and volatile trading tactics in order to generate favorable returns for their clients.
Mutual funds are accessible to all investors, although their trading options are more limited.
To outperform a benchmark index is the primary objective of a mutual fund manager.
The Primary Differences Between Hedge Funds vs Mutual Funds
Mutual fund:
➣ Pool funds from all investors with a $1 minimum commitment.
➣ Subject to U.S. Securities and Exchange Commission oversight (SEC).
➣ Available for trading on a daily basis whenever the stock market is open.
➣ Typically buy and hold stocks based on a prospectus-detailed plan.
➣ Charge a fixed fee based on a proportion of managed assets.
➣ Do not take a profit share.
➣ Can be accessed by the general public
➣ Charge a management fee (often 1% to 2%).
➣ Unable to invest in high-risk ventures
➣ Typically underperform hedge funds
Hedge funds:
➣ Pool the funds of authorized investors who have a liquid net worth in excess of $1 million or an annual income in excess of $200,000
➣ Organized as general partnerships and unrestricted by the SEC.
➣ Limited investment and withdrawal opportunities
Utilize trading tactics such as derivatives, short selling, and the purchase of alternative assets.
➣ Base fees on both performance and the amount of assets under management.
➣ Take 20% of the profit as the performance fee
➣ Are only accessible to wealthy and sophisticated investors
➣ Charge a management charge (typically 2 percent) in addition to a performance fee (often 10–30 percent).
➣ Capable of risky bets
➣ Have a tendency to outperform mutual funds
What are Mutual Funds?
Individual investors can acquire access to a managed portfolio of publicly traded securities such as stocks and bonds through mutual funds.
Investors purchase shares of a mutual fund, and the fund manager pools their money with that of other shareholders.
The management strives to accomplish the objectives outlined in the prospectus, which describes the benchmark index against which the manager’s performance will be measured and the investment approach they will employ.
Investment Strategies
Mutual funds are typically viewed as more secure investments than hedge funds.
This is due to the fact that fund managers are restricted in their ability to employ riskier techniques such as leverage, which can enhance returns but also volatility.
Mutual funds purchase publicly traded shares based on the criteria of the fund management.
These criteria could be highly narrow, such as purchasing inexpensive pharmaceutical stocks based on certain indicators, or they could be quite general, such as purchasing every stock in the S&P 500 index.
Investors in mutual funds have access to a variety of investment methods, which are outlined in the prospectus.
Types of Mutual Funds
There are several types of mutual funds that investors should be familiar with.
➣ Actively managed versus passively managed funds – Actively managed mutual funds are defined by a fund manager who systematically purchases and sells securities in an attempt to outperform the fund’s benchmark index.
Passive funds, often known as index funds, just model a portfolio based on the benchmark index in an effort to mimic its performance. Occasionally, the fund will simply purchase every security in the index.
➣ Open versus closed-ended funds – There is no restriction on the number of shares that can be issued by open-ended funds.
Investors just purchase shares, and the fund management allocates the capital to the proper holdings.
The limited number of shares in closed-ended funds eliminates the need for the portfolio manager to deal with inflows and withdrawals.
To purchase or sell shares, one must locate a buyer or seller on the open market.
➣ Load versus no-load funds – Funds pay a commission to the broker who sells the fund to the investor.
The commission is deducted either at the time of purchase (front-loaded) or sale of the mutual fund (backloaded). No-load funds lack this type of commission.
Who Can Invest?
Mutual funds are open to all investors. Certain funds may require a minimum investment of $100 to $10,000 or more.
Increasingly more funds have no minimum investment requirement today.
How Mutual Fund Fees are Calculated
Mutual funds often charge a management fee ranging between 1 and 2 percent of assets under management.
Typically, index funds have substantially lower fees. Some index funds offer costs that are close to zero percent.
Note that the management fee is distinct from fees paid in loaded funds, in which the broker receives a portion of the investors’ funds.
Annually, the management fee is paid directly to the mutual fund company.
How are Mutual Fund Regulations Implemented?
Mutual funds must register with the SEC in order to sell publicly traded shares.
The SEC enforces a number of rules, including the Securities Act of 1933, which mandates that mutual funds furnish investors with a description of the fund, information about its management, and financial statements, among other things.
The Investment Company Act of 1940 also mandates that mutual funds disclose their financial condition and investment strategies.
What are Hedge Funds?
Individual investors can use hedge funds to acquire access to the investment ideas and tactics of fund managers who they believe have a market advantage.
The structure of hedge funds is a general partnership, and investors invest directly as limited partners as opposed to purchasing publicly traded shares.
Investment Strategies
There are no restrictions on the tactics hedge funds can employ to generate positive and outsized returns for their investors.
To gain leverage, hedge funds will use derivatives such as options and margin, and they may even short-sell equities.
Additionally, hedge funds can invest in virtually any market, including cryptocurrencies, private real estate, and vintage single malt scotch.
These are tactics that are prohibited in mutual funds by SEC laws. They are also significantly riskier than merely purchasing publicly traded equities.
Who Can Make Investments?
The only investors permitted to invest in hedge funds are accredited investors.
The SEC defines an accredited investor as a person with a $1 million liquid net worth (home equity does not count) or a $200,000 yearly income (or $300,000 with a spouse).
The SEC feels that a wealthy investor is more sophisticated and better equipped to handle the volatility and uncertainty associated with hedge funds.
Frequently, hedge fund minimum investments exceed $1 million. Typically, they have restricted investment windows and minimum holding periods.
They can also impose withdrawal restrictions. Therefore, hedge fund investors require a substantial level of liquidity outside of their hedge fund investment.
How Hedge Fund Fees Are Calculated
There are two sorts of fees charged by hedge funds: management fees and performance fees.
A management fee is comparable to a mutual fund’s management fee. An expenditure ratio, normally 2 percent, is deducted annually from the fund’s assets under management.
As the name suggests, the performance fee is based on the fund’s performance and is typically 20% of the gains.
Therefore, if the fund increases by 10% in a given year, the fund retains 20% of the gains (2% of the investment) and reinvests the remainder.
If the fund incurs a loss, there is no performance charge, but investors must still pay the management fee.
2-and-20 refers to the most common fee structure, which consists of a 2 percent management charge and a 20 percent performance fee.
How Are Hedge Funds Governed?
For hedge funds to be required to register with the SEC, their total assets under management must exceed $100 million.
In addition, they are required to adhere to Regulation D of the Securities Act of 1933 and limit their investment to authorized investors.
This permits hedge funds to remain free from most SEC reporting requirements and makes investing in hedge funds significantly less transparent than investing in mutual funds.
Additional Factors to Consider Between Hedge Fund vs Mutual Fund
Even though the U.S. stock market has been on a roll over the past 15 years, hedge fund performance has deteriorated.
Due to the inability of alternative investment techniques to keep pace with the stock market, mutual funds may offer higher net returns than hedge funds during bull markets.
In bear markets, though, these tactics can be beneficial. If the returns of the techniques are indeed uncorrelated with those of U.S. stocks, they might give positive returns when the stock market plummets. When this occurs, a hedge fund will live true to its name.
While hedge funds are supported by sophisticated trading algorithms that promise high profits, they can go for extended periods without providing the desired results. For investors with patience, they could be profitable.
However, perhaps the era in which hedge funds outperformed the average investor has passed.
Today’s technology makes it easier for ordinary investors to invest and employ their own plans, regardless of how basic or intricate they are.
Mutual funds can satisfy the needs of the majority of investors, although they are rather less exciting than hedge funds. However, successful investing is typically dull.