While we are witnessing the rise of the popularity of investing, choosing the way to invest has become even more difficult. There are bonds, stocks, real estate, commodities, and a number of investment vehicles that can work as a mediator for your investment endeavor. Hedge funds and mutual funds are often seen as prime choices for investors, but they target different investors. This is raising the topic of hedge funds vs mutual funds, and what to opt for.
Hedge funds aim for more risky strategies that can result in higher returns. Mutual funds come in different forms but are regarded as a safer investment than hedge funds. This is the first, and the most obvious difference, but there are other characteristics which are also setting them apart. Fee structure, legal regulation, accessibility, and transparency are just some of them. For more in-depth analysis, stay with us.
Key Takeaways
- Hedge funds take a more risky approach to investing, trying to beat the index and generate alpha.
- Both vehicles are regulated by the SEC, but hedge funds have fewer restraints.
- Hedge funds often deal with debt and risky investments that are less liquid than those in mutual funds.
- Mutual fund fees differ between actively and passively managed funds, however are usually lower than hedge fund 2/20 fee structure.
Overview Of Hedge Funds And Mutual Funds
Hedge funds are investment vehicles that pool capital from high net worth investors. Those can be individual or institutional investors. On the other hand, mutual funds are open to the general public, including retail investors.
There are two main types of mutual funds - actively managed mutual funds and passive funds. Actively managed funds aim to beat the index by betting on often a bit riskier strategies. On the other hand, passive funds attempt to replicate returns managed by benchmark indexes.
Hedge funds are not restricted by an approach or a strategy. They can combine different strategies to generate the highest returns. Unlike mutual fund managers, hedge fund managers often use leverage to boost potential gains.
Due to fundamentally different approaches to investing hedge funds and mutual funds have different management fees and accessibility to capital.
Hedge funds almost always employ a lock-up period that can vary between one and several years, when redemption of the investment is not an option. Most mutual funds allow instant redemption to their investors.
All these differences imply a different approach to fee structures. Hedge funds use their trademark 2/20 management fee structure. 2% is the managerial fee which comes out of the total AUM of the firm, while 20% is the incentive for beating the predetermined benchmark.
Mutual funds tend to have much lower fees, which are focused on the expense ratio. That is the annual fee that is expressed as a percentage of the fund's average net assets.
Legal Structural Differences
Commonly hedge funds are structured as limited partnerships (LPs) or limited liability companies (LLCs). If the fund is founded as an LP, the responsibility is divided between general and limited partners. In an LLC all members are considered as members.
Mutual funds by their legal structure are organized as regulated investment companies (RIC). This provides them with some tax reliefs like passing the income and gains to investors without being taxed at the fund level.
Investment Strategies And Objectives
The first and the most popular hedge fund investment strategy is the so-called long/short strategy. It places bets on both long and short positions. This way a hedge fund manager can attempt to generate gain from rising long and losing short positions.
Other strategies include:
- Global macro strategy: gaining on major economic trends and geopolitical events that influence markets.
- Event-driven strategy: these high-risk investments focus on generating returns from mergers, acquisitions, and bankruptcies, which often involve investing in debt.
- Arbitrage: attempting to gain from price inefficiencies between instruments or markets.
- Activism: taking a strategic stake in a company with the aim to change it from the inside.
To amplify potential gains hedge funds often use leverage, short selling, and derivatives, increasing overall risk. Hedge fund managers are incentivized to aim for absolute returns, generating positive returns no matter the market conditions. Differences between hedge funds can be in the strategy used, geographical distribution of investments, portfolio diversification, etc.
Mutual fund investments are focused on bonds, stocks, and other fixed-income securities. Many mutual funds opt for sticking with the safe strategy of replicating the performance of benchmark indexes. Actively managed mutual funds employ some of the strategies like hedge funds, however, minus the leverage. Also, they prefer long-term capital appreciation.
Return Potential And Risk Exposure
Investing in hedge funds offers a higher return potential due to their strategy to push investments to their limits. Using higher levels of leverage allows them to boost their investments generating massive gains.
This approach comes with a higher risk exposure. Hedge funds rely on multiple risk-mitigating strategies. Some of them are the creation of a diversified portfolio among several asset classes, geographies, and sectors, stop loss orders, hedging techniques, and leverage control.
On the other end, mutual funds resort to more conservative innovation methods, that result in steady but lower gains. Index-tracking funds are a very popular type of mutual funds, and they aim to deliver similar returns to the benchmark indexes they follow. Mutual funds that conduct active investment strategies still have lower risk levels, due to lower use of debt and leverage.
Liquidity And Accessibility
Due to the high risk that comes with hedge fund investing, only accredited investors can invest in them. To be an accredited investor, one must have a $200 thousand annual income, or have a $1 million net worth.
Also, since hedge funds use sophisticated approaches which can be difficult for everyone to understand, they mostly draw sophisticated investors with wide knowledge.
Another way to keep their exclusivity is by keeping a high minimum investment threshold. Depending on the fund it can be $100 thousand, $1 million, or several million. Also, there are closed-off hedge funds that only accept new investors by recommendation.
Mutual funds are easily approachable for an average investor. They do not have a minimum initial investment limit, and most mutual funds accept as low as $1 thousand to begin with. This makes mutual funds highly accessible in comparison to an average hedge fund.
Liquidity is another crucial difference between hedge funds and mutual funds. A hedge fund is a type of investment company that often goes all in, including using borrowed money. This can be both a good and a bad thing. If the investment is a success, it will generate higher gains. If it loses, losses will rise.
Transparency In Operations
Hedge funds and mutual fund differences are also reflected in their transparency in work. The hedge fund industry is regarded by the public as an investment vehicle operating on the edge of the law. Mutual funds tend to be more open to the public, strictly presenting the results of their work.
Depending on the policy of the hedge fund, investment portfolio, holdings, and strategies can be blurred from the investors, or reported with lag. Every fund manager has their approach to transparency, which is usually the reflection of the company in which he works.
The issue of managing risk is also often unknown to individual investors, which leaves more space for managers to conduct their strategies at their will.
Hedge funds communicate with their investors mostly through quarterly and annual reports. In them, they share information regarding investment strategies, certain positions, and potential investment ideas. What the hedge funds share is often carefully weighted by the managers.
Mutual funds on the other hand offer much more transparency to investors. Like hedge funds, they also share quarterly and annual reports with the investors. However, these are required by strict regulations from regulatory bodies. In these reports, they present the current state of the portfolio, the performance of the fund, and its strategy.
Fees
As we mentioned, hedge funds charge their unique 2/20 structure fee. The 2% was counted from the total AUM the fund operates with. This is a fixed amount, and it incentivizes managers to bring in more investors. The 20% part of the fee is used in situations when the gains from an investment are higher than pre-agreed figures.
This approach was active for decades, however in recent times, it has started to evolve. Some hedge funds lowered their fees, making them accessible to more investors.
The main fees of mutual funds are management fees, which are paid to managers annually. They are usually in a range of 1% of the value of the whole fund. There are also initial sales charges which are charged when the investor buys or sells securities.
Regulatory Policies
Mutual funds are under obligation to abide by the regulatory framework under the Investment Company Act of 1940 and the Securities Act of 1933. These acts impose strict rules on how the funds are operated, and structured, and what are their disclosure requirements.
Hedge funds also must abide by the Investment Company Act of 1940. However, they heavily rely on exemptions offered by Regulation D of the Securities Act of 1933. This allows them to avoid detailed disclosure to the public like the mutual funds are obliged to.
Both of the investment vehicles are under the radar of the Securities and Exchange Commission. However, the level of scrutiny is different between them, allowing hedge funds to disclose less information in irregular time frames.
Tax Efficiency
Hedge funds are mostly registered as LLCs or LPs allowing them to rely on pass-through taxation. In reality, this means that funds do not pay taxes, but rather the individual investors.
They can utilize several tax management strategies including tax-loss harvesting, deferral of gains, and carried interests. Through tax-loss harvesting, hedge funds offset capital gains with capital losses to reduce taxable income. By opting for deferral of gains they postpone the realization of gains for the future. This way they can manage the taxing timing. By carried interest performance fees can be taxed at lower long-term capital gains. Managers this way avoid higher ordinary income rates.
Mutual funds distribute capital gains and dividends amongst the investors who are obliged to pay taxes on them. If investors are investing in mutual funds through retirement accounts, they can defer taxes on gains and income until they make a withdrawal.
What Is The Right Fund For You
This is a tough question because each individual has a set of goals and means to reach them. Mutual and hedge funds are aimed at different investors so based on their characteristics. If you know what you want, you should not have a hard time choosing where to invest.
If you are not afraid of the risk, and you want to earn higher returns, then the obvious choice is hedge funds. But, be advised, avoid investing everything you have into any fund, especially a hedge fund. If the investment fails, you need to have some capital saved.
A mutual fund is the choice for someone who is looking more long-term, and who has a lower risk tolerance. Investing in a mutual fund puts you at ease because you will not need to check every day for stock prices, and market movements. After all, most mutuals follow the indexes.
Once you make a decision, conduct due diligence and be careful where you invest. You want to place your capital with a firm that shares your values, and traits, and in which you can place your trust.