Hedge Funds vs Mutual Funds

What are “Hedge Funds and Mutual Funds”?

Both mutual funds and hedge funds are collective investment schemes that aim to achieve financial returns for their investors. By pooling investors’ money into the fund, the manager of this fund can use the capital to allocate it towards different securities.

The investors benefit from various aspects such as economies of scale, diversification, and professional management. However, there are some distinct differences between the two structures. Mutual funds are offered by asset management companies to both retail and institutional investors such as pension funds, sovereign wealth funds, insurance companies, etc. On the other hand, hedge funds are targeted at sophisticated and wealthy investors called high-net-worth individuals.

Mutual Funds

Mutual funds are very popular both among retail and institutional investors. They offer a wide variety of products that invest across multiple asset classes such as equities, fixed income, money markets, and property. Each strategy is constructed to reflect pre-set risk parameters and investment styles – for example, an equity strategy may have the mandate to invest in stocks of companies with a growth focus and large market capitalization. Although some mutual funds may use derivatives or short stocks (which increases the risk in the portfolio), the vast majority of them are vanilla long-only strategies.

Mutual funds are liquid solutions that offer investors easy access to their funds as they trade daily. In their nature, they could either be active, where a professional fund manager runs the strategy, or passive in which case the fund is aiming to replicate the performance of a particular market index.

Hedge Funds

Technically, hedge funds work on the same principle as mutual funds, they pool the funds of multiple investors together and invest them in various instruments to achieve a financial return. However, in terms of clients, they are not offered to the wider retail audience, but privately to wealthier individuals, also known as high-net-worth. Institutional investors also form a large part of hedge fund investors. Often, there is a large initial investment required.

Typically, hedge funds are not deemed as regulated investments and therefore do not have the same risk constraints that mutual funds have. In fact, hedge funds are more flexible in their approach and use very sophisticated techniques such as short-selling, derivatives trading, and may invest in illiquid assets with the idea of achieving greater returns.

As a result, they are higher risk investments and may impose lock-up periods, during which investors cannot withdraw their money. It is also important to note that hedge funds charge much higher fees than mutual funds – these normally include management fees and performance fees.