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Knowing the difference between hedge funds and mutual funds is crucial if you want to be a smart investor in today’s market. While hedge funds and mutual funds both use pooled funds to generate returns for investors, there aren’t many other similarities between the two.
This article compares the hedge fund vs. mutual funds, their key differences, and which one you should consider investing in for stable and consistent returns over time.
Hedge fund vs. mutual funds
The first key difference between hedge funds and mutual funds is the type of investor who can invest in these funds.
Hedge funds, for example, are only available to accredited investors who make over $200,000 per year or have a net worth exceeding $1 million (although the requirements are slightly different for married couples). This means that the vast majority of new and average investors will not be able to invest in hedge funds.
Hedge funds invest in a variety of alternative investments that often involve risk and speculation. Some of these investments may include derivatives or other speculative assets that hedge fund managers use to receive outsized returns atypical of the stock market as a whole.
Hedge funds are also structured much differently than mutual funds, as they are typically structured as general or limited partnerships and managed by a hedge fund manager.
On the flip side, mutual funds are a popular investment vehicle and provide many benefits to investors of all experience levels. These funds are actively managed by professional fund managers and have a track record of consistent returns and excellent diversification.
Mutual funds are one of the most widely understood vehicles in the investment industry; created in 1924 and evolving significantly over the past several decades. Today, mutual funds are ideal for diversification and for those that want to save for a comfortable retirement.
Mutual funds explained
Mutual funds pool money from many investors and allow the fund manager to invest in a wide range of different securities. One of the main reasons people find mutual funds attractive is because they are exposed to companies from many industries and provide the diversification that investors are looking for.
The value of a mutual fund is determined by the total value of the investments in the fund divided by the fund’s outstanding shares. The price of a mutual fund fluctuates intra-day, and mutual fund investors don’t own any of the companies in the fund–they only own shares of the mutual fund itself.
Mutual fund managers set investment goals based on the prospectus, which is the investing strategy and goals of the mutual fund laid out when the fund began. All mutual fund managers must issue new investors a prospectus before they invest in the fund and have the prospectus readily available.
Types of mutual funds
New investors may be surprised to hear that there are several different types of mutual funds available today. Each mutual fund intends to provide diversification to investors while capturing market gains. Below are the four types of mutual funds you may come across in your investing career.
Equity funds buy stock in many publicly held companies to help diversify the fund for investors. The majority of all mutual funds are equity funds and have some type of stock purchasing agreement.
Equity funds are ideal for young investors since they don’t have to worry about short-term fluctuations in the market. They often have decades before retirement and can ride the wave of the stock market which tends to increase over time.
Equity funds typically have three distinctions based on their size:
- Small-cap. These funds have a collective market value of $300 million to $2 billion.
- Mid-cap. Mid-cap funds are comprised of companies totaling $2 billion to $10 billion in market value.
- Large-cap. Large-cap funds are worth $10 billion or more.
Equity funds also have different investment styles that differentiate them from one another. One example is growth funds and value funds. Growth funds typically have above-average returns while value stocks tend to be stocks that investors believe are undervalued and show potential for high returns in the future.
Investors also invest in mutual funds based on their industry. For example, some mutual funds focus on technology stocks while others may target energy and solar companies. Exposure to different industries is ideal for diversification since you won’t be affected as much if one sector or industry is negatively affected by market conditions.
Equity funds may also target emerging markets, which are underdeveloped markets identified by investors as showing potential for high growth.
Fixed-income funds (or bond funds) are generally safer investments and provide a fixed return for investors. However, it’s important to understand that fixed-income funds don’t have the potential for high growth like other types of investments.
Index funds provide additional diversification since they follow one of the major stock market indexes, such as the S&P 500 or Nasdaq. Index funds are ideal for investors who value low-cost funds that don’t need much attention.
Money market funds
Money market funds are safe investments that invest in short-term debt and cash equivalents from financial institutions. Money market funds offer better returns than savings accounts but aren’t insured by the FDIC. The principal in money market funds is guaranteed, but investors shouldn’t expect to receive outsized returns from this type of mutual fund.
Specialty funds (or sector funds) are a special type of mutual fund that targets a specific industry or sector. For example, one specialty mutual fund may target real estate while others target technology or healthcare.
Within specialty funds, you’ll find regional funds and socially responsible funds. Regional funds target companies in a specific area while socially responsible funds invest in ESG companies that meet criteria set by the fund manager. For example, some mutual funds choose not to invest in companies that produce alcohol, marijuana, or tobacco for ethical reasons.
Benefits of mutual funds
Mutual funds wouldn’t be such a popular investment vehicle if there weren’t plenty of benefits for investors, including:
- Diversification. Perhaps the most important benefit of mutual funds is that they provide the best diversification compared to other similar investments. Mutual funds invest in sectors of companies, which means when one company gets hit hard your entire portfolio isn’t significantly affected. Mutual funds also make it possible to invest without having to pick stocks since they are managed by a professional fund manager.
- Liquidity. Mutual funds are generally liquid investments. They sell on major stock exchanges which means investors can convert their mutual funds into cash relatively quickly. Investments like real estate and REITs take years to see a return on investment, making mutual funds an attractive option for real estate investors and developers.
- Low cost. Companies like Charles Schwab have over 50 mutual funds that don’t charge loads, transaction fees, or investment minimums. Mutual funds are so attractive to investors since most of them have low fees while still providing diversification.
- Professional money management. Instead of spending hours researching the market, mutual funds make it possible to invest your money and have a professional money manager handle the day-to-day trading to optimize the fund for its investors. Mutual fund managers are typically industry veterans with a deep understanding of the stock market and investment management.
- Accessibility. Unlike hedge funds, almost anyone can invest in a mutual fund. Hedge funds require you to be an accredited investor while mutual funds don’t have the same restrictions. Trading on public stock exchanges is another reason why investing in mutual funds is such a great option.
Drawbacks of mutual funds
While mutual funds are the ultimate diversification tool, there are some downsides you should consider before investing.
- Potential for loss. Like all investment vehicles, there is a risk of loss. However, investors who hold mutual funds in their portfolio typically generate stable returns over time. Those looking to time the market with a short-term investment should look elsewhere.
- Cash flow issues. Mutual funds typically require investors to hold a certain percentage of their portfolio in cash to maintain liquidity. This drawback is also known as a “cash drag,” since it tends to tie up a lot of cash.
- The FDIC doesn’t guarantee mutual funds. In the event that your mutual fund depreciates in value, the FDIC will not insure or guarantee your investment.
- Dilution. Dilution takes place when a successful fund gets too big and can’t find investments for the new members of the fund. Dilution may be detrimental to the other members of the mutual fund as well.
What is a hedge fund?
A hedge fund is a risky type of investment used by accredited investors for the potential of returns that outperform the market. Hedge fund managers pool money from many investors and invest in risky assets often involving leverage and complex financial instruments. Hedge funds are considered alternative investments that some investors use for diversification as well as the potential for high returns.
Hedge funds are widely misunderstood. Contrary to popular belief, most hedge fund managers make a modest salary and work normal hours. However, the top hedge fund managers in the world routinely make over $1 billion per year from managing their hedge funds.
Hedge funds are constantly growing. Historical data shows that hedge fund assets continue to increase as more accredited investors participate in this alternative investment.
Below is a graph showing the estimated hedge fund industry assets from 1990 to 2014.
Hedge fund example
One of the best hedge fund examples is Bridgewater Associates, which is routinely ranked as the largest hedge fund in the world. Founded by Ray Dalio in 1975, the firm focuses on serving institutional clients including central banks, higher education endowments, and pension funds.
Bridgewater Associates continues to employ a macro investing approach that considers economic factors like gross domestic product (GDP), exchange rates, and runaway inflation. Dalio and Bridgewater Associates pioneered the concept of risk parity, which uses investment strategies that make their fund more resistant to market fluctuations compared to an average investment portfolio.
Hedge fund vs. index fund
Index funds are another well-known investment that tracks the companies contained within an index, such as the Dow Jones Industrial Average (DJIA) or the S&P 500. Index funds are great for new investors since they have low expense ratios and sometimes provide better returns than other popular investment vehicles.
Chairman and CEO of Berkshire Hathaway and legendary businessman Warren Buffet is a major proponent of using index funds to save for the later years of your life. He believes that index fund investing should be part of the core investment portfolio for investors who want to save for retirement. Therefore, index funds are ideal for 401(k) retirement plans and individual retirement accounts (IRAs).
Below is a graph of the historical average of the S&P 500 index. Most investors choose index funds since, historically speaking, they tend to go up over time. However, investors nearing retirement may want to focus on safer investments since the S&P can be subject to losses in economic downturns, as illustrated below.
Hedge fund vs. private equity
Private equity is an alternative investment class that focuses on growing and investing in private companies in hopes to sell them for a profit or go public on a major stock exchange. Private equity generally consists of angel investors, venture capital firms, and private equity firms that provide capital and resources to growing companies.
Private equity also involves limited partnerships that restructure private companies. Like hedge funds, private equity is seen as an alternative investment class that has different benefits and drawbacks than traditional investments.
Private equity example
One of the best examples of private equity is the founding of Facebook and its early days. The company started in 2004 and, after rapid adoption by Harvard students, took on its first outside investment by Peter Thiel, who invested $500,000 for 10% of Facebook in 2004.
This transaction is a perfect example of private equity. Thiel invested in a fledgling company that showed potential for high growth. The investment paid off for Thiel, who sold the majority of his Facebook stock for $640 million in 2012.
Hedging your investment portfolio
While only accredited investors have the ability to invest in hedge funds, there are other ways that average investors can hedge their investment portfolios, including:
Self-directed IRAs (SDIRA)
Self-directed IRAs are IRAs that allow the account holder to manage the IRA and diversify their portfolio with a tax-advantaged account. This is in contrast to a traditional IRA that has limited investment options consisting of bonds, CDs, stocks, and ETFs.
Self-directed IRAs require a custodian to supervise the investment. These custodians must be qualified and specialize in a specific asset class. Unlike traditional IRAs, custodians are prohibited from providing financial advice to investors, making SDIRAs risky for those with limited investing experience.
Knowing the difference between hedge funds, mutual funds, index funds, and SDIRAs is important if you want to be a savvy investor in today’s market. Accredited investors may look to hedge funds for diversification, while mutual funds and index funds tend to be the best option for non-accredited investors.
For more information on hedge funds, mutual funds, and other investing strategies, be sure to check out our in-depth articles on managing inflation risk, identifying highly asymmetric investments, and diversifying your wealth with inflation hedges.