Among the investment products to choose from, hedge funds and mutual funds are two options that may seem attractive. Both funds provide investors with the benefits of diversification through access to a pool of investment funds, but hedge funds are designed to target high-income investors, so 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.
What's the Difference Between Hedge Funds and Mutual Funds?
|Hedge Funds||Mutual Funds|
|Management Style||Typically actively managed||May be actively or passively managed|
|Accessibility||Typically a higher barrier to entry||Typically accessible to any investor|
|Expenses||Higher expenses||Lower expenses|
|Performance||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, which means that the manager or management team can use discretion is the security selection and the timing of trades. Mutual funds 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.
Although hedge funds and mutual funds have certain limitations on investing, such as minimum initial investment, hedge funds are not as accessible to the mainstream investor as mutual funds. For example, some hedge funds require that the investor have a minimum net worth of $1 million or they may have minimum initial investments that are much higher than mutual funds. Some mutual funds will accept any amount of initial investment, and 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 2.00%, whereas most mutual funds have expenses that are 1.00% or below. Also, hedge funds may also take a cut of the profits before passing them along to the investors.
Hedge funds are generally designed to produce positive returns in any economic or market environment, 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, while the average stock fund declines in value by 20%. During a bull market, the hedge fund might still produce low single-digit returns while the stock mutual fund could produce high single-digit to double-digit return. Over the long run, a low-cost stock mutual fund would typically 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 required to invest in hedge funds in the first place. For most investors, a diverse portfolio of mutual funds and/or exchange-traded funds (ETFs) is a smarter investment choice than hedge funds. This is because mutual funds are more accessible and cheaper than hedge funds and the long-term returns can be equal to or higher than that of hedge funds.
The Bottom Line
Hedge funds and mutual funds are structured almost identically. They pool funds from investors and invest in a wide range of securities under the management of a professional. However, beyond those basic structural 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 many investors will find they are better served by mutual funds.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.