Mutual funds and hedge funds are pooled investment vehicles. However, both of these types attract different types of investors and follow contrasting investment strategies.
Let us discuss what are mutual funds and hedge funds and their key differences.
What is a Mutual Fund?
A mutual fund is a pooled investment that collects money from several investors and invests in different assets and securities.
Mutual funds can be actively or passively managed investment vehicles. These funds are managed by fund managers and actively managed funds required greater contributions than passively managed funds.
Mutual funds are available for investment for all types of investors. They are publicly traded funds where retail investors can also invest.
The fund manager sets the investment strategy and style of every mutual fund in the prospectus. Therefore, investors can know about the investment objectives of a mutual fund before investing.
How Does a Mutual Fund Work?
Like other managed funds, mutual funds receive money from investors. A mutual fund is then set up that invests money in other assets and securities.
A mutual fund can invest in any type of security including stocks, bonds, derivatives, forex, etc.
Mutual funds are accessible to the general public and retail investors, unlike hedge funds. An investor can start investing in a mutual fund with as little as $300 in some cases.
Depending on characteristics mutual funds can be categorized in a few different ways.
Open and Close-Ended Funds
Open-ended mutual funds allow investors to invest or sell their investment at any time. These funds work like conventional securities trading on a stock market.
Closed-ended mutual funds come with restrictions on investments and lock-up periods. New investors cannot enter the pool and existing investors cannot pull out until the lock-up period expires.
Active and Passively Managed Funds
Active mutual funds look for aggressive investment strategies and higher returns on investment.
Funds managers look to beat the average returns with actively managed mutual funds. However, these funds also come with a higher degree of risk for investors.
Passive mutual funds follow the buy and hold investment strategy for the long term. In most cases, these funds follow the benchmark of an index such as the S&P 500.
Load Vs No-Load Funds
Mutual funds may offer a front-end commission to brokers or at the end when a mutual fund is sold. The commission cost is included in the investment pool’s total fund requirement.
No-load funds do not offer any commission to brokers.
Mutual funds also charge fund management fees on top of commissions. Management fee ranges from 0% to 2% in some cases.
Some mutual funds or index funds charge a lower management fee. This fee is paid to the fund managers and is included in the total running costs of the fund.
What is a Hedge Fund?
Hedge funds are also pooled investments that attract wealthy individuals and invest in different types of securities.
Hedge funds are also managed by fund managers and often deploy a team of investment experts as well.
Hedge funds consider aggressive investment strategies and look to beat the market average return or an index fund. Therefore, these funds take considerably higher risks than passively managed mutual funds or other investments.
Hedge funds can also invest in any type of security including stocks, bonds, derivatives, forex, and commodities.
How Does a Hedge Fund Work?
Hedge funds are set up as partnerships or private limited companies. Each investor gets the ownership in proportion to the investment made in the fund.
A fund manager and a team are assigned the task of fund management. Hedge fund managers devise aggressive investing strategies.
The total span of investment of a hedge fund ranges from one month to one year usually. Therefore, these funds need to take higher risks to generate sufficient returns for investors.
A key feature of hedge funds is the access to these funds. Only accredited investors can invest in hedge funds unlike mutual funds that offer access to all types of investors.
Hedge funds attract private and accredited investors. Therefore, these funds enjoy more flexibility in devising investment strategies. They can afford to take more risks in anticipation of higher returns.
An important difference between hedge funds and mutual funds is their liquidity. Hedge fund investors cannot redeem their investments at will. They follow stricter conditions that make hedge fund investment redemptions difficult as compared to mutual funds.
Mutual Funds Vs Hedge Funds – Key Differences
Let us summarize a few major differences between mutual and hedge funds.
Investment Structure and Types
Mutual funds can be open or closed-ended. They can be structured in different ways depending on the investment types.
Mutual funds have different types including:
- Open and Closed-ended funds
- Load and no-load funds
- Active and passively managed funds
Hedge funds are mostly open-ended funds where new investors can join the investment pool.
Most mutual funds come with the long term investment goals. They follow the conventional buy and hold strategy.
Therefore, these funds come with longer investment spans as compared to hedge funds. However, actively managed mutual funds may target short-term investment goals and follow aggressive strategies to harness quick and high investment returns.
Hedge funds come with a short investment span that ranges from one month to one year mostly. These funds need to bring higher investment returns.
Actively managed mutual funds bear the same risks as hedge funds more or less. These funds follow aggressive investment strategies and invest in assets that offer a high risk-reward relation.
Passively managed mutual funds do not bear many risks. They follow buy and hold investing style that aims to bring returns in the long run.
On the other hand, hedge funds bear more risks. As these funds come with a short investment span, they must yield a higher return on investment. It means hedge funds take more risks than mutual funds.
Liquidity and Lock-Up Periods
Retail investors with low investment requirements can invest in mutual funds. These funds trade publicly on stock exchanges.
Therefore, mutual funds undoubtedly enjoy more liquidity than hedge funds. However, as with any other investment vehicle, the liquidity of mutual funds also depends on their performance.
Contrarily, hedge funds are privately held investment pools. These funds do not offer the same level of liquidity as mutual funds. Investors cannot redeem their investments at their will and would need to hold until the lock-up period expires.
Mutual fund investors do not need to hold their investments or a lock-up period. Hedge funds do come with some restrictions of the lock-up period though.
Most mutual funds incur capital gains taxes when these funds are sold. Mutual funds investors can lower their income tax liabilities by holding these funds for a longer time.
Hedge fund managers receive a performance commission of around 20% typically as general partners of the LLC or limited partnership formed for the hedge fund.
Other investors are categorized as limited partners of the partnership formed. Therefore, income received from hedge funds is treated as a pass-through entity tax structure.
Management Fee and Return on Investment
The management fee or expense ratio is high which lowers the return on investment. The expense ratio of a mutual fund ranges from 1-3% usually.
The expense ratio is an annual cost for the mutual fund. Therefore, the overall payout on a mutual fund is affected greatly by this cost.
Hedge funds also incur a costly management fee of 2% and a performance fee. Hedge fund managers receive a significantly high commission as a performance fee of the total profits earned by a hedge fund.
The management fee of a hedge fund can be around 20%.
Most actively managed mutual funds generate higher returns than any other form of pooled investment vehicle. Hedge funds have seen a significantly lowering return on investment trend in recent years.
Control Over Assets and Participation
The control over assets managed by a mutual fund and hedge fund has different scenarios.
Mutual fund investors do not have any control over assets owned by the fund. Only fund managers can decide on which assets to own, control, and sell to generate profits.
Hedge fund investors are either general partners or limited partners. Both types of partners have stakes over assets owned by a hedge fund. However, the fund manager and the executive team have the power to decide on the assets held by the fund.
Prospects and Future Growth
Actively managed mutual funds have better prospects as compared to hedge funds. Other types of mutual funds can also bring good profits in the long run.
Collectively, mutual funds have good prospects and their characteristics mean they’ll continue to attract investors in the future as well.
Most hedge funds have shown declining performances in the past few years. The management costs are rising which means further lowering of profits.
However, hedge funds can be very attractive for investors in bearish markets where most investors look for diversification and hedging of investments.