Mutual Funds vs. Hedge Funds: What’s the Difference?

Both mutual funds and hedge funds are managed portfolios built from pooled funds with the goal of achieving returns through diversification. This pooling of funds means that a manager—or group of managers—uses investment capital from multiple investors to invest in securities that fit a specific strategy.

Mutual funds are offered by institutional fund managers with a variety of options for retail and institutional investors. Hedge funds target high-net-worth investors. These funds require that investors meet specific accredited characteristics.

Mutual funds are commonly known in the investment industry. The first mutual fund was created in 1924 and offered by MFS Investment Management. Since then mutual funds have greatly evolved to provide investors with a wide range of choices in both passive and active managed investments. 

Passive funds give investors the opportunity to invest in an index for targeted market exposure at a low cost. Active funds provide an investment product that offers the benefit of a professional portfolio fund management. Research giant, Investment Company Institute (ICI), states that as of Dec. 31, 2017, there were 7,956 mutual funds accounting for US$18.75 trillion in assets under management (AUM).

The Securities and Exchange Commission comprehensively regulates mutual funds through two regulatory directives: The Securities Act of 1933 and the Investment Company Act of 1940. The 1933 Act requires a documented prospectus for investor education and transparency.

Both open-end and closed-end mutual funds trade daily on the financial market exchanges. An open-end fund offers different share classes that have varying fees and sales loads. These funds price daily, at the end of trading, at their net asset value (NAV). 

Closed-end funds offer a fixed number of shares in an initial public offering (IPO). They trade throughout the trading day like stocks. Mutual funds are available for all types of investors. However, some funds can come with minimum investments requirements that can range from $250 to $3,000 or more, depending on the fund.

Generally, mutual funds are managed to trade securities based around a specific strategy. While strategy complexity can vary, most mutual funds do not heavily depend on alternative investing or derivatives. By limiting the use of these high-risk investments, it makes them better suited for the mass investing public.

According to "InvestmentNews.com" as of June 30, 2018, the three largest mutual fund asset managers included:

• Vanguard, total mutual fund assets of $3.82 trillion
• Fidelity, total mutual fund assets of $2.1 trillion
• Capital Research and Management, total mutual fund assets of $1.73 trillion

Hedge funds have the same basic pooled fund structure as mutual funds. However, hedge funds are only offered privately. Typically, they are known for taking higher risk positions with the goal of higher returns for the investor. As such, they may use options, leverage, short-selling, and other alternative strategies. Overall, hedge funds are usually managed much more aggressively than their mutual fund counterparts. Many seek to take globally cyclical positions or to achieve returns in markets that are falling.

While built around the same concepts for investing as the mutual fund, hedge funds are structured and regulated much differently. Since hedge funds offer their investments privately, this requires them to include only accredited investors and allows them to build their fund structure. Regulation D of the 1933 Act mandates investments from accredited investors in private, hedge funds.

Accredited investors are deemed to have advanced knowledge of financial market investing, typically with higher risk tolerance than standard investors. These investors are willing to bypass the standard protections offered to mutual fund investors for the opportunity to potentially earn higher returns. As private funds, hedge funds also differ in that they usually deploy a tiered partnership structure which includes a general partner and limited partners.

The private nature of hedge funds allows them a great deal of flexibility in their investing provisions and investor terms. As such, hedge funds often charge much higher fees than mutual funds. They can also offer less liquidity with varying lock-up periods and redemption allowances.

Some funds may even close redemptions during volatile market periods to protect investors from a potential selloff in the fund’s portfolio. Overall, it is vital that hedge fund investors fully understand a fund’s strategy risks and governing terms. These terms are not made public like a mutual fund prospectus. Instead, hedge funds rely on private placement memorandums, a limited partnership or operating agreement, and subscription documents to govern their operations.

According to "BusinessInsider.com" as of May 2018, the three largest hedge fund managers included:

• Bridgewater Associates
• AQR Capital Management
• Renaissance Technologies

Indexes provide one of the best ways to gauge the performance of a variety of market sectors and segments. Since hedge fund performance details are not publicly transparent it can be helpful to compare the performance of hedge fund indexes to the S&P 500 to understand the performance metrics involved in comparing hedge funds over standard mutual funds.

Fees also play a big part in performance comparison as well. Mutual fund operational fees are known to range from approximately 0.05% to as high as 5% or more. Hedge funds typically integrate what is known as a ‘two-and-twenty fee’ which includes a management fee of 2% and a performance fee of 20%.

Index performance as of March 5, 2019, shows the following gross annualized returns for the S&P 500 versus the Hedge Fund Research Index (HFRI) Fund Weighted Composite Index ®.

• Mutual funds are regulated investment products offered to the public and available for daily trading.
• Hedge funds are private investments that are only available to accredited investors.
• Hedge funds are known for using higher risk investing strategies with the goal of achieving higher returns for their investors.