Mutual funds are one of the most commonly used investment vehicles available to the general public. There are currently more than 7,500 funds making up over $16.0 trillion in assets as of February 2018.
The hedge fund industry, on the other hand, is considerably smaller, only recently surpassing the $3.5 trillion mark in total assets under management. Both mutual funds and hedge funds are similar, in that both use a professional money manager to invest a pool of funds in a diversified portfolio of investments. However, that is about the only similarity between the two investment vehicles.
Knowing the differences between mutual funds and hedge funds is important for any investor, especially if they are considering whether to add either of these investment vehicles to their portfolios.
Due to the massive size of the industry, there are many different mutual fund strategies available to the public. Everything from a pure bond fund to a pure equity fund is available in the form of a mutual fund. Even funds can be bearish toward the market, such as the Federated Prudent Bear A (BEARX) fund, which is designed for investors who want to short the market. The type of fund will typically determine the level of risk for the investor, as funds with more advanced strategies, higher concentration of equities and leverage will undoubtedly have the highest levels of risk.
Hedge funds, by comparison, are designed to carry higher levels of risk because they lack the same level of regulations as mutual funds do. Bridgewater Associates L.P. is one of the largest hedge funds in the world, with over $160 billion in assets under management. The company’s longest running fund is the Pure Alpha Fund I, which was created in 1991 and is considered a managed futures fund. This fund has the ability to hedge, leverage and employ arbitrage methodologies with exposure to many different securities and futures markets. The fund’s strategy is to provide risk-adjusted returns that are uncorrelated with traditional asset classes like the equity and bond markets.
Most investors are attracted to hedge funds over mutual funds because of the expectation of higher returns. For example, one of the top performing hedge funds for 2018 so far is the Prism Partners, L.P, which has a long equity bias as a strategy. This fund is up over 25% for the year and has provided its investors with an average annual return of 20.18% since 1999. However, these excellent returns have come at great risk too, with its largest drawdown being over 56%.
Mutual funds are highly regulated as investment companies and are monitored by the U.S. Securities and Exchange Commission (SEC). Mutual funds are also subject to strict regulation under the Securities Act of 1933, Securities Exchange Act of 1934_, _Investment Company Act of 1940 and Investment Advisers Act. The Investment Company Act of 1940 is the most specific to mutual funds of the four laws, as it is designed to regulate the structure, pricing and operation of the entire fund industry.
Hedge funds are not required to register with the SEC and are considered private offerings offered to specific investors that qualify. Therefore, hedge funds are not subject to the same four laws that mutual funds are, thus making them significantly less regulated. However, as most other investment vehicles, hedge fund managers must abide by a fiduciary standard and are subject to other laws like fraud and insider trading.
Another major difference between mutual funds and hedge funds is the qualifications to be an investor. Mutual funds typically require little qualifications and very little initial investment. For instance, Charles Schwab allows its investors to deposit as little as $100 into one of its no-load mutual funds, like the Schwab® S&P 500 Index Fund (SWPPX).
Hedge funds are a completely different story, with most requiring investors to be accredited. An accredited investor typically satisfies one of the two requirements: earned income of $200,000 ($300,000 jointly) for each of the last two years or a net worth of over $1 million (excluding primary residence). Since hedge funds are typically more risky and aggressive in nature, most generally grant only accredited investors who have a higher net worth and can withstand higher losses.
Mutual fund fees consist of sales charges and internal management fees called expense ratios. Sales charges are the commissions paid to broker dealers that come in the form of an upfront A share or level load C share. Expense ratios can range from 0.05% to as high as over 5%. Index funds are the most inexpensive form of mutual fund, like the Vanguard 500 Index Admiral (VFIAX) that has an expense ratio of 0.04%. Typically, most funds range in the 0.5% to the 1.5% range, with complex funds usually charging higher than that range.
Hedge funds operate very differently, with both a management fee and performance fee. A common expression for hedge fund fees is the ‘’https://www.investopedia.com/terms/t/two_and_twenty.asp’ target=‘_blank’ rel=’nofollow’>Two and Twenty’ rule, where the fund charges an annual management fee of 2% and an incentive fee of 20%. The incentive fee is designed to inspire managers to perform very well, as they will earn 20% of all profits over a set benchmark every year, which is usually set around the 8% mark. This incentive fee can also be a wide range, from 10% to as high as 50% of profits.
Finally, one of the last major differences between mutual funds and hedge funds is the liquidity. One of the defining characteristics of mutual funds is that they offer investors daily liquidity. Mutual funds are priced according to their net asset value and investors can have their money upon settlement one day later.
Hedge funds have no requirements on its liquidity to its investors, which adds another element of risk. Some funds allow monthly subscriptions and redemptions, while some offer longer at quarterly and annual intervals. Many funds also require a ‘lock up’ period, where initial investors are not allowed to redeem their funds for a certain amount of time, such as one to two years. Both the illiquid nature and lockup periods add additional risk to anyone potentially interested in investing in a hedge fund.
The Bottom Line
The question is not whether a mutual fund or hedge fund is better, as it is a matter of suitability and risk tolerance. With over 7,500 mutual funds available in the marketplace, an investor should be able to find a variety of funds that fit their investment needs.
On the other hand, if an investor not only qualifies for a hedge fund but more importantly is willing to withstand the risk and volatility that coincides with investing in one, the risk-adjusted returns might be worth it.