Mutual Funds vs. Hedge Funds: An Overview
Bothmutual fundsandhedge fundsare managed portfolios built from pooled funds with the goal of achieving returns through diversification. This pooling of funds means that a manager—or group of managers—uses investment capital from multiple investors to invest in securities that fit a specific strategy.
Mutual funds are offered by institutional fund managers with a variety of options for retail and institutional investors. Hedge funds target high-net-worth investors. These funds require that investors meet specific accredited characteristics.
- Mutual funds are regulated investment products offered to the public and available for daily trading.
- Hedge funds are private investments that are only available to accredited investors.
- Hedge funds are known for using higher risk investing strategies with the goal of achieving higher returns for their investors.
Mutual funds are commonly known in the investment industry. The first mutual fund was created in 1924 and offered by MFS Investment Management. Since then mutual funds have greatly evolved to provide investors with a wide range of choices in both passive and active managed investments.
Passive funds give investors the opportunity to invest in an index for targeted market exposure at a low cost. Active funds provide an investment product that offers the benefit of professional portfolio fund management. Research giant, Investment Company Institute (ICI), states that as of Dec. 31, 2019, there were 7,945 mutual funds accounting for US$21.3 trillion in assets under management (AUM).
The Securities and Exchange Commission comprehensively regulates mutual funds through two regulatory directives: The Securities Act of 1933 and the Investment Company Act of 1940. The 1933 act requires a documented prospectus for investor education and transparency.
The 1940 act provides the framework for mutual fund structuring which can fall under either an open-end or closed-end fund.
Both open-end and closed-end mutual funds trade daily on the financial market exchanges. An open-end fund offers different share classes that have varying fees and sales loads. These funds price daily, at the end of trading, at their net asset value (NAV).
Closed-end funds offer a fixed number of shares in an initial public offering (IPO). They trade throughout the trading day like stocks. Mutual funds are available for all types of investors. However, some funds can come with minimum investment requirements that can range from $250 to $3,000 or more, depending on the fund.
Generally, mutual funds are managed to trade securities based on a specific strategy. While strategy complexity can vary, most mutual funds do not heavily depend on alternative investing or derivatives. By limiting the use of these high-risk investments, it makes them better suited for the mass investing public.
According to InvestmentNews as of March 7, 2021, the three largest mutual fund asset managers included:
- Vanguard, total mutual fund assets of $3.4 trillion
- Fidelity, total mutual fund assets of $1.9 trillion
- American Funds, total mutual fund assets of $1.6 trillion
Hedge funds have the same basic pooled fund structure as mutual funds. However, hedge funds are only offered privately. Typically, they are known for taking higher risk positions with the goal of higher returns for the investor. As such, they may use options, leverage, short-selling, and other alternative strategies.
Overall, hedge funds are usually managed much more aggressively than their mutual fund counterparts. Many seek to take globally cyclical positions or to achieve returns in markets that are falling.
While built around the same concepts for investing as the mutual fund, hedge funds are structured and regulated much differently. Since hedge funds offer their investments privately, this requires them to include only accredited investors and allows them to build their fund structure. Regulation D of the 1933 act mandates investments from accredited investors in private hedge funds.
Accredited investors are deemed to have advanced knowledge of financial market investing, typically with higher risk tolerance than standard investors. These investors are willing to bypass the standard protections offered to mutual fund investors for the opportunity to potentially earn higher returns. As private funds, hedge funds also differ in that they usually deploy a tiered partnership structure which includes a general partner and limited partners.
The private nature of hedge funds allows them a great deal of flexibility in their investing provisions and investor terms. As such, hedge funds often charge much higher fees than mutual funds. They can also offer less liquidity with varying lock-up periods and redemption allowances.
Some funds may even close redemptions during volatile market periods to protect investors from a potential selloff in the fund’s portfolio. Overall, it is vital that hedge fund investors fully understand a fund’s strategy risks and governing terms. These terms are not made public like a mutual fund prospectus. Instead, hedge funds rely on private placement memorandums, a limited partnership or operating agreement, and subscription documents to govern their operations.
According to "BusinessInsider.com" as of May 2018, the three largest hedge fund managers included:
- Bridgewater Associates
- AQR Capital Management
- Renaissance Technologies
Silber Bennett Financial, Los Angeles, CA
A key difference between hedge funds and mutual funds is their redemption terms. Mutual fund investors can redeem their units on any given business day and receive the NAV (net asset value) of that day. Hedge funds, on the other hand, tend to be much less liquid. Some offer weekly or monthly redemptions, while others only offer quarterly or annually redemptions. Many hedge funds impose a lock-up period, where you cannot withdraw your money at all. During periods of market volatility, such as the most recent financial crisis, several hedge funds actually suspended redemptions entirely in order to protect the remaining investors from a potential fire sale of the fund’s portfolio. It is important to carefully read the hedge fund’s offering memorandum to fully understand your redemption rights.
Indexes provide one of the best ways to gauge the performance of a variety of market sectors and segments. Since hedge fund performance details are not publicly transparent, it can be helpful to compare the performance of hedge fund indexes to the S&P 500 to understand the performance metrics involved in comparing hedge funds over standard mutual funds.
Fees also play a big part in performance comparison as well. Mutual fund operational fees are known to range from approximately 0.05% to as high as 5% or more. Hedge funds typically integrate what is known as a "two-and-twenty fee" which includes a management fee of 2% and a performance fee of 20%.
Index performance as of March 5, 2019, shows the following gross annualized returns for the S&P 500 versus the Hedge Fund Research Index® (HFRI) Fund Weighted Composite Index.
|HFRI Fund Weighted Composite Index
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy.
MFS. "Our History."
Investment Company Institute. "Investment Company Fact Book," Page 196.
U.S. Government Publishing Office. "Investment Company Act of 1940."
U.S. Government Publishing Office. "Securities Act of 1933," Pages 32-34.
InvestmentNews. "10 largest mutual fund companies by assets."
U.S. Government Publishing Office. "Securities Act of 1933," Page 15.
Business Insider. "RANKED: The 10 biggest hedge funds in the US."
Take the Next Step to Invest
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
I have an extensive background in finance and investment, with a focus on mutual funds and hedge funds. My knowledge is based on years of experience in the industry, academic study, and staying updated with the latest trends and regulations. I have actively managed portfolios and engaged in in-depth research to understand the nuances of these financial instruments.
Now, let's delve into the concepts covered in the article "Mutual Funds vs. Hedge Funds: An Overview."
Introduction and Evolution: Mutual funds have been a significant part of the investment industry since the creation of the first mutual fund in 1924 by MFS Investment Management. Over the years, they have evolved to offer a wide range of choices, including passive and actively managed investments.
Regulation: Mutual funds are comprehensively regulated by the Securities and Exchange Commission (SEC) through the Securities Act of 1933 and the Investment Company Act of 1940. The 1933 act requires a documented prospectus for transparency, and the 1940 act provides the framework for structuring open-end or closed-end funds.
Trading and Pricing: Mutual funds can be open-end or closed-end. Open-end funds offer different share classes with varying fees, pricing daily at the net asset value (NAV). Closed-end funds have a fixed number of shares, trading throughout the day like stocks.
Investor Accessibility: Mutual funds are available to a wide range of investors, but some may have minimum investment requirements. The three largest mutual fund asset managers include Vanguard, Fidelity, and American Funds.
Private Nature and Accredited Investors: Hedge funds share a pooled fund structure with mutual funds but are only offered privately. They target high-net-worth investors and are known for employing higher-risk strategies. Accredited investors, with advanced knowledge and higher risk tolerance, are required to invest in hedge funds.
Regulation and Structure: Hedge funds are regulated differently, particularly under Regulation D of the 1933 act. They often deploy a tiered partnership structure with a general partner and limited partners, allowing greater flexibility in investing provisions.
Fees and Liquidity: Hedge funds typically charge higher fees than mutual funds and may have less liquidity with lock-up periods. Some may even suspend redemptions during volatile market periods.
Comparison in Performance: Hedge fund performance is not publicly transparent. Comparing their performance often involves looking at hedge fund indexes versus standard indexes like the S&P 500. Fees also play a crucial role in the performance comparison.
In conclusion, understanding the distinctions between mutual funds and hedge funds involves considering factors such as regulation, investor accessibility, fees, and performance metrics. Each type of fund serves different investor needs and risk appetites.