Hedge Funds vs. Mutual Funds: What’s the Difference?

A Rolex costs thousands of dollars, whereas a basic Timex goes for as little as $40. Both watches tell time, so what’s the difference? Rolex is backed by a prestigious name and an elite status. Timex, not so much.

This wristwear analogy is an excellent way to understand hedge funds versus mutual funds. They’re both convenient, fund-based investments, but hedge funds are a bit more exotic than mutual funds. They’re also pricier, generally speaking.

To understand which option best suits your goals, let’s dive into their similarities and differences in greater detail. 

How do hedge funds work?

Hedge funds, originating in the mid-20th century, were initially conceived as exclusive, high-risk investment vehicles for wealthy individuals and institutions. But what primarily sets hedge funds apart from their counterparts is their approach to risk. 

Unlike most mutual funds, hedge funds employ sophisticated strategies to generate returns while also adopting positions that help offset losses (which puts the “hedge” in “hedge fund”). These strategies typically include short selling, leverage, derivatives, and alternative investments, and they allow hedge funds to limit their correlation to average market returns.

However, hedge funds are an incredibly diverse ecosystem, encompassing complicated and esoteric strategies such as long-short equity, event-driven trading, and global macro. This diversity has attracted a wide range of investors, from affluent individuals to institutional giants like university endowments and sovereign wealth funds. 

This isn’t to say hedge funds are necessarily safer or better than other investments; after all, famed fraudster Bernie Madoff ran a hedge fund. Even decades before Madoff’s crimes came to light, Long-Term Capital Management famously blew up in the late 1990s. 

So, are hedge funds regulated now? Somewhat. They’re a little more regulated than they used to be, but investors should still carefully scrutinize hedge funds in the same way they would with any other investment vehicle.

What’s a mutual fund?

Mutual funds are stalwarts of the investment world, offering a more traditional approach to wealth-building compared to hedge funds.

Mutual funds pool money from various investors to create a diversified portfolio of stocks, bonds, or other assets, all managed by professional fund managers. The primary objective of mutual funds is to provide investors with an easy way to access a diversified mix of investments, regardless of their level of expertise or capital.

What makes mutual funds exceptionally versatile is their array of choices. Investors can opt for actively managed funds, where skilled portfolio managers make investment decisions with the aim of outperforming the market. Alternatively, there are passively managed funds that attempt to mirror the performance of a specific market index.

This variety ensures investors with diverse financial goals, risk tolerances, and time horizons can all find a suitable mutual fund option.

Mutual funds are also justifiably renowned for their convenience, allowing investors to buy and sell shares at the fund’s net asset value (NAV) at the end of the trading day.

This liquidity, coupled with professional management, makes mutual funds an extremely popular option. As of 2022, mutual funds registered in the U.S. counted more than $20 trillion in assets under management (AUM).

5 critical differences between hedge funds and mutual funds

Hedge funds and mutual funds have several critical distinctions that should significantly impact your investment calculus. These differences include liquidity, regulation, fees, accessibility, and investment strategies.

1. Liquidity 

Hedge funds

• They typically impose lock-up periods that restrict investors from withdrawing their funds for a specified duration, ranging from months to years.

• Limited liquidity can make it challenging for investors to access their money when needed, potentially leading to capital constraints.

Mutual funds

• They offer daily liquidity, allowing investors to buy or sell shares at the end of each trading day. High liquidity provides investors the flexibility to access their investments promptly, making mutual funds suitable for those who require regular access to their capital.

2. Regulation

Hedge funds

• They’re subject to less regulatory oversight compared to mutual funds. This reduced regulatory burden grants hedge funds greater flexibility in their investment strategies and fewer reporting requirements.

• However, they also imply a higher degree of risk and fewer protections for investors.

Mutual funds

• They’re highly regulated by the U.S. Securities and Exchange Commission (SEC) and other regulatory bodies worldwide. They must adhere to strict rules and guidelines, which can include limitations on the types of securities they can hold and the strategies they can employ.

• This regulatory oversight ensures greater investor protection but can also limit a mutual fund’s investment choices.

3. Fees

Hedge funds

• They typically charge both management fees and performance fees. Management fees are calculated as a percentage of AUM and are paid regardless of the fund’s performance.

• Performance fees are based on the fund’s returns and may result in significant charges if the fund performs exceptionally well.

Mutual funds

• They generally charge only management fees, calculated as a percentage of AUM. The absence of performance fees means investors won’t incur additional costs based on the fund’s performance.

• Mutual fund fees tend to be lower than those of hedge funds, making them a more cost-effective choice for many investors.

4. Investment strategies

Hedge funds

• They employ a broad range of investment strategies, including long/short equity, derivatives trading, and alternative assets such as private equity and real estate.

• This diversity of strategies lets hedge funds adapt to various market conditions and potentially generate higher returns. However, these strategies also entail higher risk and increased complexity.

Mutual funds

• They primarily focus on traditional asset classes, such as stocks, bonds, and cash equivalents. They typically employ straightforward investment strategies emphasizing diversification and asset allocation, making them suitable for risk-averse investors.

5. Eligibility and accessibility

Hedge funds

• They may require investors to meet specific eligibility criteria, often requiring them to be accredited investors with a high net worth.

• They may require an invitation from the hedge fund manager or an introduction to a hedge fund manager, making them difficult for everyday retail investors to access.

Mutual funds

• They remain open to a broader range of investors, rather than just accredited investors, with no requirement for high net worth. 

• They don’t require invitations, introductions, or access to any particular social network. In other words, you don’t have to “know a guy.”

Ultimately, the choice between hedge funds and mutual funds depends on your investment goals, risk tolerance, and liquidity requirements.

Hedge funds offer greater investment flexibility and potential for higher returns but come with higher fees and lower liquidity. Mutual funds, on the other hand, are well-regulated, cost-effective, and ideal for investors seeking simplicity and liquidity. 

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