Among the investment products to choose from, hedge funds and mutual funds are two options that may seem attractive. Both funds provide the benefits of diversification through access to a pool of investment funds. But hedge funds are designed to target high-income investors. This means they come with higher fees and minimum investment requirements.
Once you understand these and other basics, you can decide if hedge funds or mutual funds are best for your personal investment objectives. Learn more about the differences and decide which is right for you.
What's the Difference Between Hedge Funds and Mutual Funds?
|Hedge Funds||Mutual Funds|
|Typically actively managed||May be actively or passively managed|
|Typically a higher barrier to entry||Typically accessible to any investor|
|Higher expenses||Lower expenses|
|Potential for more consistent returns||Potential for higher upsides and harsher downturns|
When investing in hedge funds or mutual funds, investors do not choose the securities in the portfolio; a manager or management team selects the securities. Hedge funds are usually actively managed. This means that the manager or management team can use discretion in the security selection and the timing of trades.
Mutual funds, on the other hand, can be actively managed or passively managed. If it is the latter, the mutual fund manager does not use discretion in security selection or the timing of trades; they simply match the holdings with that of a benchmark index, such as the S&P 500.
Hedge funds and mutual funds both have certain limitations on investing. These could be minimum initial investments, for instance. But hedge funds are not as accessible to the mainstream investor as mutual funds. Some hedge funds require that the investor have a minimum net worth of $1 million. These are often much higher than those needed for mutual funds.
Some mutual funds will accept any amount of initial investment. Plus, none of them have net worth requirements.
Hedge funds typically have much higher expenses than mutual funds. For example, hedge funds often have expenses that exceed 2.0%, On the other hand, most mutual funds have expenses that are 1.0% or below.
Hedge funds may also take a cut of the profits before passing them along to the investors.
Hedge funds are designed to produce positive returns in any market environment. This is the goal even in recession and bear markets. However, because of this defensive nature, returns may not be as high as some mutual funds during bull markets.
For example, a hedge fund might produce a 4%–5% rate of return during a bear market; at the same time, the average stock fund may decline in value by 20%. During a bull market, the hedge fund might still produce low single-digit returns. The stock mutual fund could produce high single- or double-digit returns.
Over the long run, a low-cost stock mutual fund would most likely produce a higher average annual return than a typical hedge fund.
Which Is Right For You?
The average investor will not have a high net worth or the minimum initial investment needed to invest in hedge funds in the first place. For most people, a diverse portfolio of mutual funds and/or exchange-traded funds (ETFs) is a smarter choice than hedge funds.
This is because mutual funds are more accessible. They're also cheaper than hedge funds. Plus, long-term returns can be equal to or higher than those of hedge funds.
The Bottom Line
Hedge funds and mutual funds are structured in very similar ways. They pool funds from investors; then, they invest in a wide range of securities under the management of a professional.
Beyond those basic similarities, there are vast differences in goals, costs, and even in who is allowed to invest.
Hedge funds offer the potential for steady returns that outpace inflation while minimizing market risk. But most people will find they are better served by mutual funds.