10 May 2023

Differences between Hedge Funds and Mutual Funds: Unravelling the Mystery for Everyday Investors

Education

Have you ever wondered about what differentiates hedge funds and mutual funds? The investment world can, to say the least, be a little intimidating to beginner investors, especially if they have very limited financial knowledge. This article will break down the key distinctions between the two very different types of funds in simple terms, enabling novice traders to have a better understanding of their investment options.

 

What are Mutual Funds?

A Simplified Approach to Diversification

Starting with a plain definition, mutual funds are simply pooled investment vehicles that enable investors to bring their money together to buy a diversified portfolio of stocks, bonds, or other securities. This approach provides everyday investors with a simple way to benefit from asset diversification, which is the practice of spreading investments across various types of asset categories and markets to reduce risk. By investing in mutual funds, investors gain access to a wide range of securities managed by professional fund managers who make trading decisions on their behalf.

 

Accessibility and Affordability

A frequently cited main advantage of mutual funds is their ease of access. Most mutual funds have a relatively low minimum investment requirement, making them more attractive options for investors who are starting their trading journeys with limited capital. Additionally, mutual funds can be considered to have an established, and comprehensive, regulatory regime associated with them, such as the Securities and Exchange Commission (SEC) in the USA, which provides heightened levels of investor protection and transparency in investments.

 

Fees and Expenses

Mutual funds typically charge fees called expense ratios, which cover the costs of administration, management, and other associated operational expenses. These fees are, typically, expressed as a percentage of the fund’s assets and can vary depending on the fund’s management style and complexity. Passive funds, for example, which simply replicate the performance of a market index, generally have lower fees compared to actively managed funds, which involve fund managers making deliberate investment decisions in an attempt to outperform the market.

 

What are Hedge Funds?

An Exclusive Club for Sophisticated Investors

Fundamentally, hedge funds are private investment vehicles that pool the assets of high-net-worth individuals, institutional investors, and other accredited investors to invest in a wide range of assets, including stocks, bonds, commodities, currencies and derivatives. These funds are managed by experienced and specialised investment managers who typically employ complex and sophisticated investment strategies, such as short-selling, leveraging, and using derivatives to generate returns.

 

Limited Regulation and High Minimum Investments

Unlike mutual funds, hedge funds face less regulation comparatively and have more flexibility in their investment strategies. This freedom, however, comes with a catch: hedge funds are generally only available to accredited investors, who must meet certain income and net worth requirements. The SEC oversees hedge funds, albeit with less stringent rules compared to mutual funds, leading to limited transparency and allowing managers to employ high-risk strategies. Moreover, hedge funds usually have high minimum investment amounts, often in the millions, making them inaccessible to everyday and beginner investors.

 

Performance and Fees

Hedge funds aim to deliver absolute returns to their clients, meaning they seek to generate positive returns regardless of what the market conditions may be. This is different from mutual funds, which generally aim to outperform a benchmark or market index. It is, therefore, important to recognise that hedge funds may utilise complex and diverse trading strategies, some of which may involve a higher degree of risk, in their goal to achieve enhanced performance. As such, prospective investors should carefully consider the inherent risks associated with hedge funds when evaluating their investment options.

Hedge funds often charge a unique fee structure called "2 and 20," which consists of a 2% management fee on assets under management and a 20% performance fee on profits. This fee structure can be quite expensive, especially if the fund underperforms.

 

Comparing Mutual Funds and Hedge Funds

Key Differences at a Glance

  • Investor Base: Mutual funds cater to a broader range of investors, including beginners with limited capital, while hedge funds are exclusive to accredited investors with a high net worth or income.

  • Investment Strategies: Mutual funds typically follow a more straightforward investment approach, while comparatively, hedge funds employ complex and sophisticated strategies.

  • Regulation: Mutual funds are highly regulated, providing investors with transparency and added protections, whereas hedge funds face fewer regulations and can be opaquer.

  • Minimum Investment: Mutual funds usually have lower minimum investment requirements, whereas hedge funds demand high minimum investments.

  • Fees: Mutual funds charge expense ratios that vary based on the fund’s management style, while hedge funds have a “2 and 20” fee structure that can be quite expensive.

 

Key Takeaways

Mutual funds and hedge funds are fundamentally different investment vehicles that cater to distinct investor types and offer unique investment strategies, regulation levels, and fee structures. Mutual funds provide everyday investors with accessibility, diversification, and professional management, while hedge funds are exclusive to accredited investors and utilise complex strategies to achieve absolute returns. Understanding these differences is vital for individual investors to choose the best option based on their financial goals and risk tolerance.


Disclaimer: Any information presented is for general education and informational purposes hence, not intended to be and does not constitute investment or trading advice or recommendation. No opinion given in the material constitutes a recommendation by M4Markets that any particular investment, security, transaction or investment strategy is suitable for any specific person.

It does not take into account your personal circumstances or objectives. Any information relating to past performance of an investment does not necessarily guarantee future performance.

Harindale Limited does not give warranty as to the accuracy and completeness of this information.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 85% of retail investor accounts lose money when trading CFDs with this provider.

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