The 5 Main Differences between Mutual Funds and Hedge Funds

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By guest writer Himani Arora

In a previous article, we did an illustrative introduction on hedge funds. In ‘Investing your money wisely’ we also mentioned mutual funds. But what are really the differences between mutual funds and hedge funds? Both of them are managed portfolios under a pooled investment scheme. This means, by pooling funds, the financial risk attached to different asset classes is diversified and the management fees are spread among different investors. So when you buy a unit of a fund, you only bear a smaller portion of the risk and the fees attached to it, than if you had bought each instrument in the fund separately. However there are several differences that make hedge funds trickier than mutual funds.

1. Accessibility

By requiring a higher minimum investment to enter the fund (generally around hundreds of thousands of dollars), hedge funds are only made available to large institutions like pension funds or banks, and to high-net-worth individuals.  On the other hand, mutual funds are made to attract ‘regular investors‘ through lower costs and a lower barrier to entry.

2. Returns

Hedge funds aim for absolute  positive returns even if the market is not doing well. Whereas, mutual funds function on a relative approach and aim to perform higher than a benchmark (e.g.: a stock index).

3. Investment strategy

In order to always provide absolute positive returns regardless of  market performance, hedge funds tend to be much more aggressive in their investment strategies.  Thus, the types of instruments in a hedge fund tend to be more complex. Also, hedge funds tend to run more concentrated and riskier portfolios, which mutual funds sometimes can’t due to regulation and investor relations. Finally, hedge funds investment strategies tend to be less liquid (i.e. your money might be locked in for a certain period of time) and more leveraged (i.e. more use of debt, derivatives, asset-backed securities or short selling to increase returns).

4. Regulation

Mutual funds are among the most strictly regulated financial products. They are subject to numerous requirements designed to ensure they operate in the best interests of their shareholders. Therefore their structure, operation and investment strategies are highly scrutinized. Hedge funds on the other hand are considered private investments and are subject to far less regulatory oversight.

5. Cost

Unlike mutual funds, there are no limits on the fees a hedge fund manager can charge to his investors. So they tend to be more expensive than mutual funds on a daily basis. However, by aiming for higher profits, the net returns can still be much higher than for mutual funds.

Author BioHaving varied interests and diverse knowledge, Himani Arora writes articles for several sectors and categories in personal finance, mutual funds and investments for reliancemutual.com

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