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Hedge Funds vs. Mutual Funds: Understanding the Difference

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Maximizing returns is one of the main goals of investing. But how do you know which investment vehicle to choose? You are probably familiar with mutual funds and may have heard of hedge funds. Read on to learn about how these funds work, how they differ and which one is best for you to maximize your investment returns while minimizing your risk.

Hedge Funds vs. Mutual Funds at a Glance

Hedge funds and mutual funds are two different types of investment funds. Hedge funds are typically private, riskier and only accredited investors are allowed to invest in them. Mutual funds are available for the public to invest in and trade to meet near-term, mid-term and long-term goals.

Here’s a quick comparison of seven key differences between the two types of investment funds.

Type Hedge Funds Mutual Funds
Who and How A few established, accredited investors pool money into an investment portfolio to purchase high-risk assets. Investors pool savings into a market securities bucket at generally affordable costs.
Funds Contribution Substantial personal financial investment Low minimum; no mandatory minimum contribution
Types of Investors Firms and individuals with high net worth and high risk tolerance Individual retail investors with limited disposable income
Types of Regulation Loose, limited regulation Exchange-regulated; stricter
Types of Owners Not many Many thousands
Funds Management Style Extremely aggressive Less aggressive; aligned with investment objectives
Performance Fees Performance-based Managed assets based; charged as a percentage

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The objective of hedge funds is to offer a few established investors a portfolio of investments to purchase assets, while mutual funds aim to offer investors returns that exceed the risk-free market rate of return.

Hedge Funds Explained

Hedge funds pool investors’ money together and invest in securities or other types of stock market investments. Here are some characteristics of hedge funds:

A Look at Mutual Funds

Mutual funds are investment funds that pool many investors’ money together to purchase stocks, bonds and other market securities. Investors include individuals, companies and other organizations. Mutual funds are attractive to investors who:

How Hedge Funds Perform vs. How Mutual Funds Perform

Hedge funds’ performance is based on the managed assets. Mutual funds’ performance is based on the number of required investors. Investing in hedge funds is riskier and typically results in higher returns; however, hedge funds have recently had less than stellar returns. Mutual funds’ returns are typically lower and carry less risk.

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Measuring Performance

Investors and fund managers generally use five methods to measure funds’ performance:

  1. Alpha. A financial ratio that shows the returns that a fund generates above the fund’s benchmark-generated returns.
  2. Beta. Uses regression analysis and reflects a portfolio’s volatility compared to the market. You can see how your portfolio’s returns tend to fluctuate with the market.
  3. Expense Ratio. A ratio of a fund’s total expenses to its assets. It reflects the per-unit cost of fund management.
  4. Fund Portfolio Allocations. Shows the diversification of a fund’s portfolio. The fund fact sheet gives you the details of your assets.
  5. Rolling Returns. The average annual returns for a certain time looking at the fund’s assets through the last day of the period.

Similarities Between Hedge Funds and Mutual Funds

Hedge funds and mutual funds have more differences than similarities; however, here are a couple of things that they do have in common:

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Fees

Hedge funds charge a set management fee — usually 2% — and a performance fee, which is usually between 10% and 30%. Mutual funds only charge a management fee — usually set between 1% and 2%.

Mutual fund fees are more heavily regulated than hedge fund fees. Hedge fund investors can expect to pay more the better the fund performs.

What Do You Need To Know Before Investing in Hedge Funds vs. Mutual Funds?

Hedge fund investment regulations are more stringent than regulations on mutual funds. Using a hedge fund is not as easy as withdrawing money from your bank account and depositing it with an online trading platform. Keep these things in mind before you invest in hedge funds or mutual funds:

Before Investing in Hedge Funds

  1. You must be an accredited investor.
  2. You must know and understand your risk and risk tolerance.
  3. You must know and understand how to determine fund values.
  4. You must know and understand your fund manager fees.
  5. Review and evaluate your prospective fund manager’s qualifications.

Before Investing in Mutual Funds

  1. You must understand expenses and loads and how they apply to your prospective mutual fund.
  2. Check to see if your mutual fund is diversified.
  3. Review and evaluate your prospective fund manager’s qualifications.

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Accredited Investor Qualifications

If you choose to go the hedge fund investment route, be sure that you meet the following criteria according to Rule 501 of Regulation D of the 1933 Securities Act:

Good To Know

The money in mutual funds is held, or in other words, locked, for several years. The holding period of investments in hedge funds varies and is based on the fund strategy. This period ranges from microseconds to years.

Should You Invest In Hedge Funds or Mutual Funds?

If you don’t think that you qualify as a high net worth accredited investor, then hedge fund investing might not be for you. Consider investing in mutual funds instead.

If you qualify as a high net worth accredited investor, read stock performance charts to see how hedge funds perform in a bear market compared to mutual funds. Both fund types are susceptible to market downturns and have fees that can eat into returns. Consult a fund manager to help you make the right decision for your investment goals.