Those new to fund investing will be forgiven for grouping these types of funds under the same umbrella, but while hedge funds and mutual funds can seem similar from a cursory glance, the two are actually wildly different beasts.
First, the similarities. Both hedge funds and mutual funds work by pooling capital from a large number of investors and investing it with the aid of a fund manager for a predetermined fee. And that's where the similarities end.
The key difference between the two is that hedge funds chase the big fish – investments that are high risk, high reward. Mutual funds, on the other hand, stick to the shallows where they can catch smaller but more reliable returns. Here's how they do it.
Mutual funds:
- Don't take share from the profit
- Are available to the general public
- Charge a management fee (normally 1–2%)
- Can't make high-risk investments
- Tend to perform worse than hedge funds
Hedge funds:
- Take ~20% performance fee from the profit
- Are available only to high-net-worth and sophisticated investors
- Charge management fee (normally 2%) plus performance fee (normally 10–30%)
- Can make high-risk investments
- Tend to perform better than mutual funds
Hedge funds are typically more aggressive than their mutual fund counterparts. While investment strategies differ from fund to fund, hedge funds typically aim to generate a profit regardless of whether the market is going up or down. Towards this goal, managers of hedge funds have the ability to use high-risk tactics, such as short selling stocks and taking speculative positions in derivative securities.
In contrast, mutual funds cannot take such highly leveraged positions, making them less risky, but also limiting their potential returns.
Hedge funds are only directly available to sophisticated and high-net-worth investors ('accredited investors'). Normally these are investors who have a net worth exceeding $1m (excluding their primary residence) or an annual income of over $200,000 maintained for the previous two years (the levels vary from country to country). The minimum investment amounts for participation in a hedge fund are typically far higher as a result.
This isn't the case for mutual funds, which are open to retail investors and often have a low minimum investment threshold.
Hedge funds are free to trade in anything they like, whether that's stocks and derivatives, land, real estate, bitcoin, public securities, life insurance, lottery tickets or a mine on the other side of the world.
In contrast, mutual funds are limited to investing in publicly traded securities, i.e. stocks and/or bonds.
Hedge funds charge both a set management fee (normally set at 2%) and a performance fee (typically varies from 10% to 30%), meaning as an investor, you will pay more the better the fund performs. The most common fee structure is known as ‘two and twenty’: a 2% asset management fee plus a 20% cut of any profits returned.
This structure is a bit of a hard sell for many investors since the fund manager gets the asset management fee – which can run into the millions – regardless of how well the fund performs. However, it is worth noting that part of the reasoning here is that hedge fund managers tend to have their own money in the game, which helps align their interests with those of the fund performing well.
Mutual funds charge only a management fee, which is typically set at around 1–2%, and are heavily regulated around the amount and types of fees they can charge.
The period of time a hedge fund holds its investments can vary wildly depending on its fund strategy, from microseconds (such as with HFT firms) to years (Global Macro).
With a mutual fund, your money is locked away for several years.
Mutual funds are strictly regulated regarding the amount of capital that can be invested, the period of time in which earnings should be invested and overall investment strategy.
Hedge funds are restricted by no such regulations. This is in part the reason why such stringent criteria exist around who can invest in a hedge fund in the first place.
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