Mutual Funds vs. Hedge Funds: What’s the Difference? (2024)

Mutual Funds vs. Hedge Funds: An Overview

Bothmutual fundsandhedge fundsare managed portfolios built from pooled funds with the goal of achieving returns through diversification. This pooling of funds means that a manager—or group of managers—uses investment capital from multiple investors to invest in securities that fit a specific strategy.

Mutual funds are offered by institutional fund managers with a variety of options for retail and institutional investors. Hedge funds target high-net-worth investors. These funds require that investors meet specific accredited characteristics.

Mutual Funds

Mutual funds are commonly known in the investment industry. The first mutual fund was created in 1924 and offered by MFS Investment Management. Since then, mutual funds have evolved to provide investors with a wide range of choices in both passively and actively managed investments.

Passive funds allow investors to invest in an index for targeted market exposure at a low cost. Active funds provide an investment product that offers the benefit of professional portfolio fund management.

More than 115 million investors held shares in 9,346 mutual funds in 2022, according to research giant Investment Company Institute (ICI), with those funds holding $22 trillion in assets under management (AUM).

Regulation

The Securities and Exchange Commission comprehensively regulates mutual funds through two regulatory directives: The Securities Act of 1933 and the Investment Company Act of 1940. The 1933 Act requires a documented prospectus for investor education and transparency; the 1940 act provides the framework for mutual fund structuring which can fall under either an open-end or closed-end fund.

Trading

Both open-end and closed-end mutual funds trade daily on the financial market exchanges. An open-end fund offers different share classes that have varying fees and sales loads. These funds price daily, at the end of trading, at their net asset value (NAV).

Closed-end funds offer a fixed number of shares in an initial public offering (IPO). They trade throughout the trading day like stocks.

Generally, mutual funds are managed to trade securities based on a specific strategy. While strategy complexity can vary, most mutual funds do not heavily depend on alternative investing or derivatives. By limiting the use of these high-risk investments, it makes them better suited for the mass investing public.

Largest Mutual Fund Managers

The three largest mutual fund asset managers are:

• Vanguard, with $5.1 trillion in mutual fund assets
• Fidelity, with $2.6 trillion in mutual fund assets
• BlackRock, with $307 billion in mutual fund assets
  

Hedge Funds

Hedge funds have the same basic pooled fund structure as mutual funds. However, hedge funds are only offered privately. Typically, they are known for taking higher-risk positions with the goal of higher returns for the investor. As such, they may use options, leverage, short-selling, and other alternative strategies.

Overall, hedge funds are usually managed much more aggressively than their mutual fund counterparts. Many seek to take globally cyclical positions or to achieve returns in markets that are falling.

Regulation

While built around the same concepts for investing as the mutual fund, hedge funds are structured and regulated much differently. Since hedge funds offer their investments privately, this requires them to include only accredited investors and allows them to build their fund structure. Regulation D of the 1933 Act mandates investments from accredited investors in private hedge funds.

Accredited investors are deemed to have advanced knowledge of financial market investing, typically with higher risk tolerance than standard investors. These investors are willing to bypass the standard protections offered to mutual fund investors for the opportunity to potentially earn higher returns. As private funds, hedge funds also differ in that they usually deploy a tiered partnership structure which includes a general partner and limited partners.

Trading

The private nature of hedge funds allows them a great deal of flexibility in their investing provisions and investor terms. As such, hedge funds often charge much higher fees than mutual funds. They can also offer less liquidity due to varying lock-up periods and redemption allowances.

Some funds may even close redemptions during volatile market periods to protect investors from a potential selloff in the fund’s portfolio. It is vital that hedge fund investors fully understand a fund’s strategy risks and governing terms. These terms are not made public like a mutual fund prospectus. Instead, hedge funds rely on private placement memorandums, a limited partnership or operating agreement, and subscription documents to govern their operations.

Largest Hedge Fund Managers

Based on total assets under management, the top hedge funds as of 2023 include:

• Citadel ($339 billion AUM)
• Bridgewater Associates ($196.8 billion AUM)
• AQR Capital Management ($120 billion AUM)

Comparing Performance

Indexes provide one of the best ways to gauge the performance of a variety of market sectors and segments. Since hedge fund performance details are not publicly transparent, it can be helpful to compare the performance of hedge fund indexes to the S&P 500 to understand the performance metrics involved in comparing hedge funds over standard mutual funds.

Fees also play a big part in performance comparison as well. Mutual fund operational fees are known to range from approximately 0.05% to as high as 5% or more. Hedge funds once commonly integrated what was known as a "two-and-twenty fee," which included a management fee of 2% and a performance fee of 20%. However, the average hedge fund fee has come down somewhat, with management fees averaging 1.37% in 2020 and performance fees averaging 16.36%.

Index performance as of Feb. 17, 2024, shows the following gross annualized returns for the S&P 500 versus the Hedge Fund Research Index® (HFRI) Fund Weighted Composite Index.