Last Updated on April 7, 2023 by George
To be a wise investor in today’s market, you must understand the distinction between the hedge and mutual funds. The only significant similarity between the two is the use of pooled funds by mutual funds and hedge funds to produce returns for investors.
This essay contrasts mutual funds with hedge funds, outlines their main differences, and recommends which one you should invest in if you want steady profits over time.
The first significant distinction between the hedge and mutual funds is the sort of investor who can invest in these funds.
For instance, accredited investors can only invest in hedge funds if they make over $200,000 a year or have a net worth of at least $1 million (although the requirements differ slightly for married couples). As a result, many novice and average investors can only invest in hedge funds.
Hedge funds make investments in a variety of risky and speculative alternative assets. Hedge fund managers may use derivatives or other speculative assets in some of these investments to achieve returns disproportionate to the overall stock market.
Hedge funds are often set up as general or limited partnerships and are run by a hedge fund manager, which makes them organized very differently from mutual funds.
On the other hand, mutual funds are a well-liked form of investing and offer numerous advantages to investors of all experience levels. These funds have a history of steady returns and significant diversification, and qualified fund managers actively manage them.
Having been around since 1924 and undergoing significant development in recent years, mutual funds are among the most well-known investment instruments. Investing in mutual funds now is a great way to diversify your portfolio and preserve money for a comfortable retirement.
Mutual Funds Explained
Mutual funds allow the fund manager to invest in various securities because they aggregate the money from numerous investors. Mutual funds are famous for numerous reasons, including the fact that they expose investors to businesses across various industries and offer the diversification that investors need.
A mutual fund’s value is calculated by dividing its investment value by the number of outstanding shares. Investors in mutual funds only own shares of the mutual fund; they do not own any of the firms that make up the fund; instead, the price of a mutual fund fluctuates throughout the day.
The prospectus details the mutual fund’s investing strategy and objectives and is the basis for managers setting investment objectives. Before participating in the fund, all mutual fund managers must provide a prospectus to new investors and have it on hand.
Types of Mutual Funds
The fact that there are currently numerous distinct types of mutual funds accessible may surprise new investors. Each mutual fund aims to profit from market gains while offering investors diversification. The four types of mutual funds you can encounter in your investing journey are listed below.
Investment funds
Equity funds purchase ownership in numerous publicly traded firms to help investors diversify their holdings. Equity funds, which often have some stock-purchasing arrangement, make up most of all mutual funds.
Young investors should use equity funds since they can invest without concern for short-term market changes. They frequently have a long time before retirement and can ride the upward trend of the stock market.
Based on their size, equity funds are often divided into three categories:
- Small-cap. The market value of these funds ranges from $300 million to $2 billion.
- Mid-cap. Companies with a market capitalization of $2 billion to $10 billion make up mid-cap funds.
- Large-cap. Large-cap funds have a value of at least $10 billion.
Equity funds differ from one another by having various investment approaches. Growth and value funds are two examples. Value stocks are often those that investors believe are undervalued and have the potential for significant returns in the future, whereas growth funds typically have returns that are above average.
According to their industry, investors also put money into mutual funds. For instance, while some mutual funds specialize in energy and solar industries, others may concentrate on technology stocks. Exposure to various industries is excellent for diversification because you will only be as significantly impacted if one sector or business suffers from adverse market conditions.
Developing nations
Equity funds may also focus on emerging markets, which are developing nations that investors believe have a strong potential for growth.
Fix-income investments
Bond or fixed-income funds offer a fixed return to investors and are typically safer investments. It’s crucial to realize that, unlike other investment kinds, fixed-income funds have little potential for rapid growth.
Indexed funds
Since index funds track one of the major stock market indices, such as the S&P 500 or Nasdaq, they offer additional diversity. Investors that value low-cost, low-maintenance investments should favor index funds.
The money market
Investments in short-term debt and cash equivalents from financial institutions are made through money market funds, which offer investors safety. Money market funds don’t have FDIC insurance but provide higher returns than savings accounts. Money market funds have guaranteed capital, but investors shouldn’t anticipate disproportionate gains from this class of a mutual funds.
Funds with a Niche
A unique kind of mutual fund that focuses on a particular business or sector is known as a specialty fund (also known as a sector fund). One specialty mutual fund, for instance, would focus on real estate, while others focus on technology or healthcare.
Regional funds and socially conscious funds can be found in specialized funds. While socially conscious funds invest in ESG companies that fulfill specific criteria established by the fund manager, regional funds focus on businesses in a particular region. For ethical grounds, some mutual funds, for instance, avoid investing in businesses that manufacture alcohol, marijuana, or tobacco.
Benefits of Mutual Funds
If there weren’t so many advantages for investors, such as the following, mutual funds wouldn’t be such a well-liked investment option:
- Diversification. Mutual funds offer the finest diversity compared to comparable investments, which may be their most significant advantage. Mutual funds invest in specific business sectors, so your entire portfolio isn’t significantly impacted when one company suffers a lot. Since mutual funds are managed by a qualified fund manager, investing in them is also possible without choosing specific stocks.
- Liquidity. In general, liquid investments include mutual funds, and investors can instantly turn their mutual funds into cash as they trade on well-known stock exchanges. Mutual funds are a popular choice for real estate investors and developers because investments like real estate and REITs take years to show a return on investment.
- Low price. Around 50 mutual funds offered by companies like Charles Schwab don’t have loading, transaction fees, or investment minimums. Investors find mutual funds appealing because they typically have minimal costs while offering diversification.
- Expert financial management. Mutual funds allow you to invest your money without spending hours researching the market, and a seasoned money manager will handle the day-to-day trading to maximize the fund for its investors. Mutual fund managers are frequently seasoned business professionals with extensive knowledge of the stock market and investment management.
- Accessibility. A mutual fund allows practically anyone to invest, unlike hedge funds. While mutual funds do not have the same restrictions as hedge funds, you must be an accredited investor to invest in a hedge fund. Another reason investing in mutual funds is a terrific choice is trading on open stock exchanges.
Drawbacks of Mutual Funds
Although mutual funds are the best instrument for diversification, there are some drawbacks to consider before investing.
- Possibility of loss. Loss is a possibility, just like with another investment vehicle. Yet, portfolios of investors using mutual funds often produce steady returns over time. Short-term investors who want to time the market should go elsewhere.
- Money flow problems. To ensure liquidity, mutual funds often demand that investors store a specific proportion of their holdings in cash. Due to how much money it tends to tie up, this disadvantage is often characterized as a “cash drag.”
- The FDIC does not protect mutual funds, and the FDIC will not safeguard or guarantee your investment if the value of your mutual fund declines.
- Dilution. When a profitable fund grows too large and struggles to find opportunities for its new investors, dilution occurs. The other mutual fund participants may suffer from dilution as well.
What is a Hedge Fund?
Accredited investors may employ a hedge fund as a hazardous investing strategy to earn returns that surpass the market. Hedge fund managers combine a variety of investors’ funds and make hazardous investments that can include complicated financial instruments and leverage.
Hedge funds are regarded as alternative investments, and some investors utilize them to diversify their portfolios and potentially earn large profits.
People frequently misunderstand hedge funds. Contrary to widespread assumption, most hedge fund managers have regular jobs and modest salaries. However, the top hedge fund managers worldwide typically earn more than $1 billion from managing their hedge funds each year.
Hedge funds are expanding all the time. Historical data demonstrates that hedge fund assets continue to rise as more accredited investors engage in this alternative investment.
The estimated hedge fund sector assets from 1990 to 2014 are depicted in the graph below.
Hedge Fund Example
Bridgewater Associates, which is sometimes listed as the biggest hedge fund in the world, is one of the best instances of a hedge fund. The company, which Ray Dalio founded in 1975, specializes in serving institutional clients like central banks, endowments for higher education, and pension funds.
Bridgewater Associates still uses a macro-investing strategy that considers variables like the GDP, currency exchange rates, and runaway inflation. The idea of risk parity, which Dalio and Bridgewater Associates popularized, employs investment tactics to make a fund more resilient to market changes than the typical investment portfolio.
Index Fund Versus Hedge Fund
Another well-known investment is index funds, which follow the stocks included in an index like the S&P 500 or the Dow Jones Industrial Average (DJIA). Since index funds have low expense ratios and can offer higher returns than other well-liked investing vehicles, they are excellent for novice investors.
Warren Buffet, the famed billionaire and chairman of Berkshire Hathaway, strongly supports using index funds to invest for your retirement. He thinks index fund investing should be included for investors looking to build a solid investment portfolio and put money aside for retirement. In light of this, index funds are the best choice for 401(k) and individual retirement accounts (IRAs).
The S&P 500 index’s historical average is depicted in the graph below. As index funds have traditionally increased in value over time, most investors opt for them. Yet, because the S&P can experience losses during economic downturns, as demonstrated below, investors who are getting close to retirement may wish to concentrate on safer investments.
Hedge Fund vs. Private Equity
One alternative investment category is a private equity, which focuses on developing and funding private businesses to either sell them for a profit or make them publicly traded. Angel investors, venture capital corporations, and private equity firms are the leading players in private equity; they fund and support developing businesses.
Limited partnerships that restructure private corporations are also an element of private equity. Private equity is an alternative investment class with different advantages and disadvantages from regular investing, much like hedge funds.
Private Equity Example
The beginnings of Facebook serve as one of the best illustrations of private equity. After being quickly adopted by Harvard students when it was launched in 2004, the firm received its first outside investment from Peter Thiel, who contributed $500,000 for 10% of Facebook in the same year.
This deal is an excellent illustration of private equity. Thiel invested in a startup business with solid development potential. Thiel’s investment was profitable; he sold most of his Facebook stock in 2012 for $640 million.
Hedging Your Investment Portfolio
Hedge funds are only accessible to accredited investors, although there are various ways for regular investors to diversify their holdings, including:
IRAs with self-direction (SDIRA)
Self-directed IRAs give the account holder control over the IRA and a tax-advantaged account to diversify their portfolio. This contrasts with a standard IRA, which only offers a limited selection of bonds, CDs, equities, and ETFs as investment possibilities.
SDIRAs allow investors to make alternative investments in various asset types, including real estate, precious metals, limited partnerships, etc.
Custodian oversight is necessary for self-directed IRA investments, and these custodians must be knowledgeable and focused on a particular asset class. In contrast to conventional IRAs, custodians are not permitted to give investors financial advice, making SDIRAs riskier for beginners.
Final Thought- Hedge Fund Versus Mutual Fund
To be an intelligent investor in today’s market, you need to understand the differences between hedge funds, mutual funds, index funds, and SDIRAs. Hedge funds are a potential source of diversity for accredited investors, whereas mutual funds and index funds are typically the best choices for non-accredited investors.
Check out our in-depth articles on controlling inflation risk, discovering highly asymmetric investments, and diversifying your wealth with inflation hedges for additional information on hedge funds, mutual funds, and other investing strategies.
