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Understanding the Basic Differences Between Hedge Funds and Mutual Funds

Understanding the Basic Differences Between Hedge Funds and Mutual Funds

While hedge funds provide maximum returns, mutual funds are less riskier of the two. This WealthHow article has enlisted some vital points for understanding the basic differences between hedge funds and mutual funds.
Madhushree Kelkar
Quick Tip
According to a June 2013 report in Wall Street Journal, wealth managers were recommending hedged mutual funds. These are investment instruments which utilize the strategies of hedge funds, but incorporate the transparency and ease in tradeability of mutual funds.

While hedge funds and mutual funds have several similarities and both are pooled and professionally managed investment funds, there are striking differences which set the two apart. If you are a rookie investor, you must know about the difference between a hedge and mutual fund so that you can invest wisely. For example, there is an initial minimum investment requirement for hedge funds, which is around USD 1 million or more, unlike mutual funds. Also, as a majority of small investors invest in mutual funds, they are closely scrutinized and regulated by the SEC.
As hedge funds often have large but fewer investors, it is not regulated tightly. Also, mutual funds do not leverage, while hedge funds do. Hence, before you make an investment decision, understanding the basic differences between hedge funds and mutual funds is very important. Here are few points that will tell you the same.
Hedge funds Mutual funds
It is an aggressively managed investment portfolio, contributed to by few investors, and it undertakes complex investment strategies for generating higher returns. They are private offerings which are managed by hedge fund managers. It is a collective investment scheme where money is collected from investors in order to buy securities. They are public offerings which are managed by mutual fund managers.
Rules for Investing
According to the U.S. Government, only accredited investors who meet certain criteria are able to invest in hedge funds. Anyone can invest in mutual funds, anytime.
Number of Investors
Investors are limited to 100 or 500, depending on the funds collected. There is no limit to the number of investors.
Regulated by U.S. Securities and Exchange Commission (SEC)
No, they are not regulated by SEC. Yes, they are tightly regulated by SEC.
Mitigating Losses
Implement various hedging techniques for survival. No other option but to exit positions and convert to cash.
Type of Return on Investment
Irrespective of the market conditions, these aim at getting absolute returns. The returns depend on the prevailing market conditions, and their relativity to the index benchmark.
Tools for Investment
Include high-risk investment tools like leverage, short-selling, volatile derivatives, like options, futures, commodity trading, etc. Include lower-risk investment options like stocks, commodities, real estate, money market instruments, and bonds.
Manager Fees
As the nature of work is critical, they get a fixed amount of fees over and above their performance incentives. Remuneration to mutual fund managers depends on the performance of the portfolio.
They have absolute zero liquidity as they have lockup periods, and an investor is not allowed to withdraw or sell them for a certain period. They have a higher liquidity as they can be easily sold and purchased according to the wish of the investor.
Performance in Bear Market
Because of hedging, they perform relatively better. Mutual funds may not be able to perform like hedge funds.
Disclosure of Asset Allocation
Disclosure of asset allocation not required Required to disclose asset allocation in every quarter and file periodic paperwork.
Marketing Efforts
As there are few investors, marketing efforts are limited. Mutual funds need to undertake aggressive marketing to gain investors.
Not priced on a regular basis, and investors may keep a tab at the end of the month. Performance is priced daily and is made known to the public.
Change in strategy can be easily incorporated in hedge funds. Hence, they are flexible. Strategy changes cannot be easily incorporated. If undertaken suddenly, they will be touted as 'style drift'.
Offered Through
They are offered through private placement memorandum. They are offered through prospectus.
Limited only to the rich and high-net worth investors. Affordable for average investors who do not have too big sums to invest.
Risk and Returns
They involve a greater risk, and therefore, generate higher returns. They have lesser risk, and hence, yield lower returns.
As they are aggressive in nature, they often resort to leveraging. Mutual funds cannot leverage positions.

Remember that hedge fund managers are often required to invest on the hedge funds they manage, while there is no such requirement for mutual fund managers. Mutual funds are usually smaller in value, their managers do not have to look for high-yielding 'creative ideas' for investment like hedge fund managers. Now that you know about the performance and other differentiating factors between hedge funds and mutual funds, hope you will invest wisely.