An Introduction to Mutual Funds and Hedge Funds
Mutual funds and hedge funds are similar in that they are both investments in stocks and bonds with the aim to make money. Both are overseen by a manager or group of managers who decides which securities will perform well and places them into a portfolio which investors buy a piece of, and then participate in the gains and losses of that package. The biggest advantage of both for investors is that they offer an opportunity for diversification and professional management of their money.
Mutual Funds in More Detail
However, there are significant differences between mutual and hedge funds. Mutual funds must register with the U.S. Securities and Exchange Commission and then make reports periodically of their results. This means that the funds are under the rules and regulations of government oversight. Mutual funds use a wide variety of investments including not only stocks and bonds, but commodities and real estate as well.
Mutual funds, which generally fall into three categories of Equity Funds, including investments in stocks, fixed-income funds (mainly bonds), and money-market funds, vary in terms of risks and rewards. Some mutual funds are riskier than others, but every fund has some level of risk because no investment is free of it. A starting investment in a mutual fund is usually around $1,000 and some offer automatic purchase plans of $50 a month. There are fees that mutual fund investors must pay, but they are usually only about 1 to 2 percent each year.
Hedge Funds in More Detail
Hedge funds do not have to register with the SEC, hence they do not have to submit reports on their activity to the government. Investors in hedge funds will have to open an account with at least $100,000 to $1 million. And if the fund’s worth increases, investors are charged a “performance fee” of 20 percent or more. That’s in addition to a yearly 2 percent fee.
Some of the allure of hedge funds is that they are able to invest in riskier investments than mutual funds. These include investments in derivatives, options, futures, and short selling. This allows hedge funds to ring up profits even when the market is on a downtrend. Hedge fund investors are those who are considered to have high net worth. They get that title after the U.S. government labels them “accredited investors” following an extensive review. Hedge fund investors include institutions, millionaires, and billionaires able to go through the long and restrictive process that it takes to become an accredited hedge fund investor.
Moving from Mutual to Hedge Funds
One way for the small investor to gain entrance into the lucrative hedge fund market without being “accredited” is to invest in a fund of hedge funds. These can be purchased with a minimum of as low as $25,000, but there will be two fees that must be paid. The way the fee structure works is that each hedge fund under the overall umbrella might charge a fee of one to two percent of the assets that are under management, along with a profits fee of 15 percent to 25 percent. Also, the fund of hedge funds will usually charge its own fees.
When we look at a comparison of returns between hedge funds and mutual funds we see that there are dramatic differences. While the average mutual fund returns over a three-year period were 2.07 percent and over 10 years were 1.8 percent, hedge funds recorded returns of 8.8 percent over the same three years and 3.7 percent gain over the 10-year period.