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Hedge Fund vs. Mutual Fund

Step-by-Step Guide to Understanding the Hedge Fund vs. Mutual Fund Differences

Last Updated February 20, 2024

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Hedge Fund vs. Mutual Fund

Hedge Fund vs. Mutual Fund: What are the Similarities?

Hedge funds and mutual funds are both pooled investment vehicles designed to generate returns on behalf of their investors.

The construction of the portfolio for either type of fund includes diversification as a form of risk management and limiting the volatility in returns.

Hedge funds are categorized under active management because a fund manager actively tracks and adjusts the portfolio accordingly based on fundamental analysis, technical indicators, and current market trends to achieve the fund’s target return.

Like hedge funds, mutual funds are also professionally managed investment vehicles. However, not all mutual funds are actively managed, as some are passively managed.

  • Active Management → An actively managed fund strives to outperform the benchmark index, most often the S&P 500, i.e. “beat the market”.
  • Passive Management → In contrast, a passively managed fund tracks an underlying benchmark to “match” the performance of the index.

In either case, the fund manager raises capital from their investors by outlining their investment strategy, including historical data regarding their past returns performance to date, i.e. the fund’s track record.

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Hedge Funds vs. Mutual Funds: What are the Differences?

Hedge funds are recognized for relying on riskier investment strategies to achieve higher returns on behalf of their investors.

The common investment strategies employed by hedge funds to earn outsized returns are much broader in scope.

  • Long-Short Equity Fund (L/S)
  • Equity Market Neutral Fund (EMN)
  • Short-Only Fund (Short Selling)
  • Event-Driven Fund (“Special Situations”)
  • Arbitrage Fund (e.g. Merger Arbitrage, Convertible Bond Arbitrage)
  • Activist Fund
  • Global Macro Fund
  • Distressed Debt Fund
  • Quantitative Funds (Systematic Trading)
  • Multi-Strategy Hedge Funds (“Multi-Strat”)
  • Credit Fund

Hedge funds also frequently utilize other methods to further increase returns, such as leverage (i.e. reliance on borrowed funds), short selling, and other complex financial instruments such as derivatives and options.

By strategically undertaking riskier bets on specific individual equities – or speculating on industry-specific or secular trends – hedge funds rely on more aggressive tactics to outperform the broader market.

In contrast, the strategies utilized by actively managed mutual funds are more conservative and closely aligned with more established strategies for producing long-term returns.

For example, mutual funds frequently adhere to the long-term “buy-and-hold” strategy based on lower-risk investment themes. Of course, there are exceptions, but most mutual funds only utilize long-only strategies.

Mutual funds tend to be far more risk-averse in their investment strategies while steering away from riskier tactics such as leverage, short selling, and complex financial instruments like derivatives.

The usage of riskier strategies could perhaps generate higher returns on behalf of a mutual fund, yet the potential for incurring steep capital losses is not part of the business model.

The prospectus of the mutual fund states its specific approach towards portfolio management and risk mitigation strategies, i.e. the fund investment strategy is constructed with predefined risk parameters. In fact, an abrupt disconnect from the original strategy pitched to the fund’s investors and predefined in the prospectus can cause a contractual violation of the terms.

With that said, the performance of mutual funds tends to be closely correlated to the market index that it is tracking.

But part of the core appeal of hedge funds is the fact that returns are uncorrelated to the broader market, so at least in theory, a hedge fund should perform better in a market downturn.

Mutual Fund vs. Hedge Fund

Comparison Between Mutual Funds vs. Hedge Funds (Source: HSBC)

Learn More → Hedge Fund Primer

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Hedge Fund vs. Mutual Fund: What is the Difference in Fee Structure?

The more actively involved a fund manager is in monitoring the investment portfolio and adjusting the holdings, the higher the fee structure is charged to investors.

The classic fee structure inherent to the hedge fund industry is the “2 and 20”.

  • 2% Management Fee → The 2.0% management fee is intended to cover the operating costs of the fund, such as the firm’s overhead costs and compensation for the team of investment analysts.
  • 20% Performance Fee → The 20.0% fee is the performance fee contingent on the firm meeting the target return. Hence, the performance fee functions as an “incentive” for the fund manager to achieve its returns threshold, i.e. 20% of earnings in excess of a predefined benchmark return.

Similar to a hedge fund, a mutual fund also charges a management fee to cover the overhead and administrative costs incurred by the fund.

The amount allocated to support the fund’s operational costs is determined via the expense ratio, which equals the annual operating expenses divided by the average fund assets.

Expense Ratio (%) = Annual Operating Expenses ÷ Average Fund Assets

In comparison to the management fee charged by hedge funds, the fee tends to be substantially lower for actively managed mutual funds – ranging around 0.5% to 1.0% in most cases – and there is rarely a performance fee.

Learn More → Mutual Funds

Hedge Funds vs. Mutual Funds: What are the Regulatory Differences?

Mutual funds are highly regulated by the Securities and Exchange Commission (SEC). For the sake of offering full transparency to their investors, mutual funds must report their net asset value (NAV) on a daily basis.

On the other hand, hedge funds are subject to fewer regulations and less regulatory oversight, which reduces the burden of being required to abide by strict rules to promote transparency.

On a related note, the fact that less stringent regulations are placed on hedge funds is only applicable to accredited investors, which comprises high net worth individuals and institutional investors such as pension funds and university endowments.

The high barriers to entry with regard to the criteria established by the SEC and initial investment requirements – as well as the lock-up period in which investors cannot access their funds – are intentional constraints, i.e. the limited partners (LPs) of a hedge fund are more sophisticated and understand the risks being undertaken.

The criteria to qualify to invest in a hedge fund is significantly more challenging compared to a mutual fund, wherein practically any investor can invest, even retail investors. To invest in a mutual fund, the minimum investment amount is substantially lower, or in certain instances, there is no set minimum investment at all.

Generally put, investment vehicles where the potential investor base is wider with lower barriers to entry tend to be regulated more closely by the SEC to protect the interests of investors, particularly retail investors.

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