Should You Invest in Hedge Funds or Mutual Funds?

If you've ever wanted to ask someone, "What is a hedge fund?", never fear! The term hedge fund is a catch-all that describes numerous types of arrangements in which a private investment partnership or company, run by a manager who works for a fixed fee, share of the profits, or some combination thereof, raises capital from outside investors and deploys that capital according to a predetermined strategy, perhaps even within a narrowly defined asset class.
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The hedge funds vs. mutual funds debate can be made simple with a clear understanding of the key similarities and differences between the two types of funds. Once you understand the basics, you can decide if hedge funds or mutual funds are best for your personal investment objectives.

Hedge Funds vs. Mutual Funds: The Similarities

There are only a few similarities between hedge funds and mutual funds. These similarities may also be considered as advantages for most investors.

Here are the key similarities of hedge funds and mutual funds:

  • Pooled Investments: Hedge funds and mutual funds are pooled investment types, which means that the assets are comprised of money from multiple investors pooled together into one portfolio.
  • Diversification: Hedge funds and mutual funds both provide diversification by investing multiple securities. It’s important to note, however, that some funds are highly concentrated in one particular security type or sector of the economy. Typically, hedge funds are highly diversified into different security types, such as stocks, bonds, and commodities, whereas most mutual funds have stated objectives and invest in just one type of security or category.
  • Professional Management: 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.

    Hedge Funds vs. Mutual Funds: The Differences

    The differences between hedge funds and mutual funds are the key deciding factors for choosing which is best for the individual investor.

    Here are the key differences between hedge funds and mutual funds:

    • Accessibility: 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 have minimum initial investments as low as $100 and none of them have net worth requirements.
    • Expenses: 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.
    • Objective/Performance: 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.

      Bottom Line on Hedge Funds vs. Mutual Funds

      The greatest advantage of hedge funds may be their potential for producing steady returns that outpace inflation while minimizing market risk. However, the average investor will not have a high net worth or minimum initial investment often required to invest in them 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.

      Disclaimer: The information on this site is provided for discussion purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

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