Hedge funds and mutual funds can be mistaken for each other. They are both pools of money collected from individual and institutional investors such as pension funds and college endowments.

However, that’s where the similarity ends. Hedge funds are for the wealthy and for institutions that have large blocks of money to invest. They can take bigger, riskier bets on more types of financial instruments. Mutual funds are for individual investors, using safer, well-established strategies for producing returns on investment.

“Most mutual funds just cannot take the same level of risk that the hedge funds can, because they’re open to everyday investors,” explains Titan analyst Vincent Ning.

Let’s take a look at both types of investments.

What is a hedge fund?

A hedge fund is a private pool of money, collected from what are known as accredited investors—institutions and individuals with required amounts of wealth and/or income and ability to tolerate risk. The hedge fund is organized as a limited partnership, with the investors as the limited partners and the fund organizer as the managing partner.

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Hedge fund strategy and investment choices can be wide-ranging—trading in assets beyond stocks and bonds (such as derivatives and property), short-selling as well as buying, and borrowing large amounts of money to make leveraged bets on assets.

Hedge fund types include those that simultaneously buy and sell related securities or assets (long/short), those that bet on changes in macroeconomic variables such as interest rates (macro), or those seeking to profit from temporary price discrepancies in related assets (arbitrage).

What is a mutual fund?

A mutual fund is a pool of money collected from any and all investors who have a minimum amount to invest. Some mutual funds require no minimum initial investment, but most funds require at least $500, sometimes more. Mutual funds are organized as trusts or corporations, and are regulated by the Securities and Exchange Commission. With few exceptions, they confine themselves to buying registered securities (stocks and bonds), don’t take short positions, and don’t use leverage, or borrowed money.

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Mutual funds are described by the focus of their strategy—such as US small-cap stocks or corporate bonds with high credit ratings. Other funds mimic the performance of an index such as the Standard & Poor’s 500 Index. A balanced fund holds a mix of stocks and bonds.

Similarities between hedge funds and mutual funds

There are a couple of notable similarities between mutual funds and hedge funds.

• Hedge funds and mutual funds pool money from investors and try to generate the best returns, subject to any operating rules or regulatory constraints placed on the fund managers.
• Both try to diversify, spreading the pool of money in different investments as a way to limit risk.

Differences between hedge funds and mutual funds

There are several differences between hedge funds and mutual funds to keep in mind.

• Hedge funds are available only to more sophisticated investors such as institutions and high net-worth individuals; mutual funds are available to the general public.
• Hedge funds require investors to commit their money for at least one year—a period known as a lockup—before any withdrawals can be made; mutual fund investments can be redeemed at any time.
• Hedge funds can make high-risk investments that are off-limits to mutual funds.

Hedge funds are designed to do better than mutual funds in volatile or declining markets; mutual funds generally outperform in bull markets when prices are steadily rising.

Measuring performance

Mutual funds measure their returns relative to returns for a recognized standard or benchmark, and relative to returns for similar types of funds in a peer group.

For example, a mutual fund whose strategy is to invest broadly in the US stock market will gauge its returns against a benchmark such as the S&P 500’s returns.

Peer-group comparison is simply a fund’s return compared against other mutual funds with the same strategy. For example, a large-cap stock fund is compared against other large-cap funds.

Hedge funds rely on absolute return. A hedge fund manager’s focus is on generating a positive return, or mitigating losses. For example, in a year when stocks on average declined 5%, a hedge fund that generated a 3% return would be considered a success.

The past decade’s bull market has meant strong returns for stocks and stock mutual funds. Hedge funds have lagged, by comparison. In every year from 2011 to 2020, the S&P 500 Index outperformed the Barclays Hedge Fund Index, often by substantial margins.

Fees

Mutual fund managers are paid a fee, often less than 1% of the value of the fund’s money under management. They don't get a cut of the profits. Because the management fee is based on total assets under management, mutual fund managers have a strong incentive to increase the size of their funds.

Hedge fund managers receive a management fee and get a percentage of the fund’s returns. Most funds use the 2/20 system for compensating managers: 2% of the total money under their management, and 20% of any returns above an agreed minimum.

Hedge fund vs. ETF vs. mutual fund

Hedge funds by definition are actively managed, with more frequent purchases and sales of securities than mutual funds. But many mutual funds are also actively managed, with management fees and expenses associated with buying and selling securities.

An increasingly popular alternative is exchange-traded funds, or ETFs, which mostly track indexes and other market benchmarks. Most are passively managed, meaning the ETF manager makes only minor adjustments to the fund to keep it tracking the benchmark, so the costs are low compared with hedge funds and actively managed mutual funds.

The bottom line

Mutual funds are a much bigger investment universe than hedge funds, and a financial advisor may be able to help the average investor create a diversified portfolio with mutual funds rather than individual securities. A hedge fund might serve as a component of a portfolio for certain wealthy or big investors, rather than be the entire portfolio.