Mutual funds are investments that pool money from multiple investors and invest it in stocks, bonds or other securities. They’re a primary way for most people to invest in several financial instruments. Mutual funds are also called open-ended funds because they have no fixed end date. In contrast, hedge funds can be closed-ended (with an expiration date) or open-ended (no set expiration). This article discusses crucial things to know about mutual funds and hedge funds.
What are hedge funds?
Hedge funds are privately managed pooled investment vehicle that uses various strategies to produce positive, absolute returns in any market condition. They are an alternative investment with a high level of risk.
Alternative investments are unconventional financial assets. They include private equity, venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts.
Hedge funds are not regulated by the Securities and Exchange Commission (SEC) because they were created for sophisticated investors who want to invest money in alternative investments. There are two types of hedge funds: short-biased and long-biased.
Short-biased hedge funds use techniques such as short selling to profit from falling prices. Short selling is when you borrow shares from an institution and sell them at the current price. If the stock’s value drops, then you buy back your shares at a lower price and make a profit. A long-biased hedge fund uses the technique of buying a stock and holding it for several years in anticipation of future growth.
What are mutual funds?
Mutual funds are a type of investment vehicle that pools money from many investors to purchase securities. They are professionally managed, which means that the fund manager makes all the investment decisions. Mutual funds are not guaranteed, so investors may gain or lose money.
Types of hedge funds
Hedge funds can be categorized in these ways:
This could be long-only, short-only, or both long and short strategies; market neutral strategies; directional bets on sectors like energy or financials; relative value strategies that try to exploit pricing differences between similar assets (e.g., convertible bonds); and more.
Arbitrage, event-driven investments whereby managers bet that a certain event will occur (e.g., merger), merger arbitrage (buying stocks before a merger announcement), distressed debt investing (buying up companies’ debt when it’s cheap because the underlying company is struggling financially), or buying up risky assets such as mortgages if you believe there’s no risk at all of defaulting borrowers paying back their loans because housing prices will skyrocket forever, and so on.
An example can be seen in short-term Venture Capital Funds (VCFs) which are designed for investors looking at holding investments for less than one year while longer duration funds are meant for those planning an investment horizon of five years or more.
Hedge Fund vs Mutual Funds
Hedge funds are generally considered to be more expensive than mutual funds because there’s a higher management fee involved. Also, they offer higher returns and are riskier. Mutual funds have lower fees in general, which means that if you invest in one, you’ll be able to keep more of your returns over time.
Hedge funds typically require large amounts of capital and it’s usually those who have high net worths that can afford them. In addition, hedge funds are harder for investors with no experience in finance or economics to understand fully because most companies offering this type don’t have any official documentation available online like traditional companies do.
Though hedge funds are more expensive than mutual funds, they are more tax efficient. Mutual funds typically charge fees ranging between 0% and 2%. Hedge funds often charge management fees between 1% and 3%, plus performance fees of 20% or more if the investor receives positive returns from investing in them; this means that investors could pay a total fee as high as 35%.
However, hedge funds often use complex trading strategies like short selling — selling borrowed stock that you don’t own — which can help lower taxable income for some investors by offsetting gains with losses from other investments held within your account (for example stock splits).
Drawbacks of Hedge Funds
Though hedge funds can be more profitable, more flexible and tax efficient than mutual funds, there are a few drawbacks:
- They are not regulated like mutual funds.
- Hedge funds do not disclose their holdings or even their value as often as mutual funds do.
- Hedge fund managers can charge high fees—sometimes over 2% per year—and these fees can eat into your potential returns if you don’t understand how they work and how to minimize them.
- Lack of transparency. It is difficult for investors to know what types of investments individual hedge funds have made or how much risk those investments entail without doing extensive research on the fund itself. This means that there may be surprises when you cash out your portfolio at some point in the future. If you had known exactly what was in each investment held by a particular fund before buying shares from them, then you might have chosen differently with your money!
- Finally and most importantly: many people are simply not suited for investing in these kinds of instruments because they require more active involvement than other kinds (such as mutual funds). They also tend towards larger minimum investments than most individuals would normally consider worth putting upfront.
Benefits of mutual funds
Compared to hedge funds, mutual funds are easier for the average investor to invest in.
Mutual funds are also regulated by both the SEC and FINRA. This means that they’re subject to strict oversight by regulatory bodies, which keeps them honest and protects small investors from being taken advantage of by unscrupulous fund managers or brokers.
Mutual funds are more transparent than hedge funds because they must disclose their holdings on a regular basis. You can track what is going on with your money at any time because trading activity is published more frequently if there has been significant movement.
In addition, many mutual fund companies offer online tools such as live feeds that allow you to keep tabs on how well your investments are doing at any given time.
How to invest in hedge funds
Hedge funds are usually only available to accredited investors, but a small number of hedge funds have started accepting non-accredited investors as well. If you want to invest in hedge funds and don’t meet the high net worth requirements, open an account with any one of many online brokerages that offer access to a limited selection of hedge fund investments.
Your brokerage will charge fees based on the amount of money you put into your account and there may be other charges associated with using their services as well—don’t forget about them when comparing prices! It’s important not just because they could end up costing more than what was advertised originally but because these fees can add up quickly depending on how much money is invested overall within each account holder’s portfolio.
Hedge Funds and Private Equity
Hedge funds and private equity are both alternative investments, but they are different in a few ways. For example, hedge funds are more liquid than private equity (meaning you can withdraw your money more easily) and more regulated than private equity (so you have some assurance that the managers will not do anything too risky).
Unlike hedge funds, private equity is less transparent: There’s no way to track how your money is being invested or even how much money has been raised by the fund manager to invest.
Lastly, hedge funds offer greater flexibility in terms of what types of investments they can make—they can buy stocks or bonds but also other assets such as real estate or commodities. Some people prefer one because it matches their personal investment style; others may choose the other because of its potential for growth over time.
Which is riskier: hedge fund or mutual fund?
- Mutual funds are less risky than hedge funds.
- Mutual fund investors are protected by a series of federal laws, while hedge fund investors are not.
- Hedge funds offer more flexibility than mutual funds but come with higher fees and greater complexity.
Hedge funds are not for everyone, but if you have the means to invest in one, it can be a very lucrative opportunity. One thing that is important to remember when considering whether or not hedge funds are right for you as an individual investor is that there is no guarantee of success—or even consistency! Hedge fund managers only do their best to maximize returns while minimizing losses.
Mutual funds are a good investment option for individuals who want to invest in the stock market and need some help managing their portfolio. They are also ideal for those who want to save money for retirement but don’t have much experience with investing. Mutual funds offer the diversification, low costs and tax efficiency which make them attractive investments all around.