Mutual Funds vs Hedge Funds: What's the Difference?

Mutual funds and hedge funds are professional investment operations that pool capital from outside investors to earn returns, but the similarities mainly end there. Mutual and hedge funds use very different strategies to achieve their objectives and seek capital from distinct clientele. In this article, you’ll learn how both types of investment companies work, their fundamental differences between them, and the requirements for investors to participate.

Mutual Funds

Mutual funds pre-date the Great Depression and are among the oldest pooled investment vehicles. The idea behind mutual funds is similar to that of insurance policies where policyholders contribute money to a large pool and draw from it when accidents occur. But with mutual funds, the pooled money goes toward buying assets like stocks or bonds to achieve a particular investment objective.

Mutual funds combine investor funds to create a large capital base to buy assets. While portfolios vary in size depending on the fund’s objectives, mutual funds typically provide diversification without requiring significant upfront capital. For example, a portfolio of 50 large-cap stocks might require $10,000 or more to construct by yourself, but a mutual fund can provide the same portfolio for an initial investment as low as $1,000. Thousands of mutual funds are available to investors all over the world, ranging from high-risk equity funds to low-risk fixed-income vehicles.

Types of Mutual Funds

Do you want to invest in a broad portfolio of stocks? There’s a mutual fund for that. How about bonds with laddered maturity dates for income? There’s a mutual fund for that, too. A mix of stocks and bonds that automatically adjusts holdings to become more conservative over time? Yep, they’re called target-date funds.

Here are a few fund categories you might consider for your portfolio:

• Equity Funds: These funds hold a mix of stocks grouped by category, such as growth stocks or small-cap companies. More straightforward investment strategies tend to have lower expense rates.
• Bond Funds: Bond funds contain fixed-income assets from governments or corporations with the goal of producing consistent income. They can hold a mix of assets based on duration, issuer or risk level.
• Money Market Funds: Mutual funds that invest only in short-term fixed-income or cash-like assets are known as money market funds. These funds have a low risk profile since durations are often less than one year and liquidity is high.
• Index Funds: The cheapest mutual funds are index funds since they aren’t managed by a professional stock picker. Index funds simply track an index like the S&P 500 or the Bloomberg US Aggregate Bond Index in an attempt to mimic its return.
• Specialty Funds: A fund that tracks a specific sector or region is known as a specialty fund. These funds track particular assets based on a theme, like consumer staples stocks or European-based companies. Specialty funds typically have higher expense rates than equity or index funds.

Who Can Invest in Mutual Funds?

One of the primary benefits of mutual funds is their accessibility. Mutual funds have reasonably straightforward objectives that are easily laid out in the fund’s prospectus. Because mutual funds are transparent and subject to strict regulations, they’re open to institutional and retail investors of all levels.

The one requirement? An initial capital infusion. Mutual funds typically require an initial investment of $1,000 to $3,000, although this can sometimes be waived. Some brokers also levy commissions or load charges on mutual funds, but many funds can be purchased for no commission or fee outside the expense rate.

Hedge Funds

Hedge funds were initially conceived as a way to hedge against risk, but today’s hedge funds are involved in a variety of asset classes and trading techniques that aren’t always focused on risk mitigation. Hedge funds aren’t a monolith; each company has its own investment strategies and goals, often at odds with others in the industry. 

So, what is a hedge fund like today? Unlike mutual funds, hedge funds employ sophisticated and complex strategies to achieve their goals. They are subject to less regulatory oversight than mutual funds and can invest in a broader range of assets and derivatives. Investing in a hedge fund has the potential for greater returns but also carries unique risks. As such, you can only invest in hedge funds if you have met certain criteria, which shows you have the capacity to take on the higher risks associated with them.

Hedge fund fees, minimum investment amounts, and redemption terms can vary greatly by fund. However, a 2% asset-based management fee and a 20% performance fee (tied to performance) are common. Most performance fees include a high-water mark, which ensures that fund managers only earn performance fees on net new profits, preventing them from being rewarded multiple times for recovering losses. Investment minimums range from $100,000 to $1 million. 

Investing in a hedge fund also typically involves keeping your capital in the fund for a certain length of time, known as a lockup period, before you are eligible to request a redemption. The lockup length varies by fund but typically ranges from one to three years. Many hedge funds employ rolling lockups where each additional investment is subject to a new lockup period. There are also special circumstances where funds may place illiquid assets into a "side pocket" that is not subject to normal withdrawal terms. In addition, hedge funds can limit redemptions to prevent liquidity issues, so you may be unable to sell shares when you want.

Types of Hedge Funds

In an attempt to achieve their lofty performance goals, hedge funds employ complicated strategies that mutual funds cannot utilize. A hedge fund’s goal is always absolute alpha —  to make as much money as possible given the risk level, asset allocation, and market environment.

While there are many different types of hedge fund investment strategies, some of the most common ones include:

• Long/Short Equity: This strategy involves buying certain stocks while shorting others, attempting to profit from short-term mispricings. These funds vary in risk level depending on the stocks and leverage applied to the trade.
• Global Macro: These funds use a wide range of assets, including currencies, foreign equities, and commodities, to bet on global economic trends.
• Market Neutral: A true ‘hedging’ strategy, market-neutral funds aim to profit in any environment by offsetting long and short positions. They tend to be less volatile than long/short equity or global macro, but returns are often lower as well.
• Event-Driven Funds: If there’s a currency collapse or unpredictable election result, event-driven funds are there to profit from the resulting uncertainty. These funds also look for corporate events like mergers, acquisitions, defaults, or C-suite replacements.
• Quant Funds: This strategy uses computer models and algorithms to identify trading opportunities based on statistical and mathematical analysis. Quant funds often trade in high volumes and rely heavily on data and technology.
• Credit Funds: Focusing on debt securities, such as corporate bonds, sovereign debt, or credit derivatives, these managers analyze creditworthiness and macroeconomic trends to identify opportunities for profit.
• Multi-Strategy: As the name suggests, these hedge funds employ multiple strategies across different asset classes and markets. This can look like combining long/short equity, global macro, and event-driven strategies within the same fund with the goal of generating returns in various market conditions.

Who Can Invest in Hedge Funds?

Unlike mutual funds, the threshold for investing in hedge funds is steep, and hedge funds aren’t available to most of the investing public. In addition to the high fees, lockup periods, redemption rules, and minimum investment amounts, hedge funds are only available to experienced, wealthy investors have access who can understand and bear the high risks.

Accredited Investors

To invest in hedge funds, you must be an accredited investor, meaning you have:

• A net worth of $1 million (excluding primary residence)
• An annual income of $200,000 in the last 2 years (or $300,000 if married filing jointly)

There are a few rare exceptions to this rule, like '40 Act Funds (Hedge Fund Mutual Funds), which are mutual funds are structured to follow hedge fund-like strategies but are registered with the SEC under the Investment Company Act of 1940. These funds are open to the general public and do not require accredited investor status but may not offer the same risk-return profile as traditional hedge funds.

Qualified Purchasers

Many hedge funds, specifically the larger and more sophisticated ones, have even more stringent investor restrictions, requiring investors to be Qualified Purchasers. 

For individuals, this means holding $5 million or more in investments (not net worth). For entities (like family offices, corporations, pensions, endowments, etc.), this means owning and investing at least $25 million in investments. A trust can typically qualify as a Qualified Purchaser if it was not formed for the specific purpose of acquiring securities and holds at least $5 million in assets.

Key Differences

Hedge Funds are More Sophisticated than Mutual Funds but Riskier and More Expensive

Hedge funds are often considered the investment playground of the rich and powerful, but the truth is a little more mundane. Hedge funds are just like any investment company, with varying levels of risk, asset allocation, and objectives. And while hedge funds are costly and limited to accredited investors, they don’t always beat the market and frequently clash with each other.

If you aren’t an accredited investor, mutual funds are a simple and direct way to diversify your portfolio. If you have the capital and investing experience to participate in hedge fund strategies, be sure to understand the goals of the fund and the assets involved. It's always a good idea to consult with a financial advisor before putting any capital to work in either mutual funds or hedge funds.

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