Hedge Funds vs Mutual Funds

Commodities, Investing Psychology Jun 9, 2020 / Reading Time: 3 mins
By Divik Nigam Reading Time: 3 mins

Often these two terms get thrown around in the financial world without knowing their true functionalities and meanings. Today we will delve into what these institutions are, how they work and the perks of investing into either of them.

Both hedge funds and mutual funds consist of managed portfolios that aim to provide returns that beat an index fund through various investing strategies. Investors are able to select from an array of categories and tailor their own investment preferences, but the ultimate decision of where and when to invest their capital, is decided by the portfolio manager.

In essence, this elucidates that investors are able to ‘ride the waves of profits’ under the guidance of professional fund managers, whose knowledge and awareness of the impact of various events in the financial markets is funnelled by the eyes and ears of highly experienced research analysts.

Mutual Funds vs Hedge Funds

Mutual funds operate in a similar manner to hedge funds, they however differ when it comes selecting who can invest and their investing strategies. Whilst both are investing institutions, hedge funds operate privately to accredited investors, which may be in the form of high net worth individuals (HNI), who tend to be more ‘risk-loving’ and are willing to stake their capital on a lower probability of a higher return. The increased flexibility of hedge fund investors allows for investment into riskier and sophisticated asset classes and strategies such as options, short-selling, warrants and gearing. The participation in higher risk strategies implies a greater level of monitoring and thus a higher management fee is associated with hedge fund investing. This will be further outlined in the section below.



The performance of hedge funds and mutual funds may play a key role into choosing which fund investors prefer. Ultimately, the goal of most mutual funds is to beat an associated index fund (relative) and whereas the goal of passive mutual funds is to match the risk and return of the index itself under the assumption that in the long term, markets will always be the outperformer. Hedge funds on the other hand, as stated by Morgan Stanley, “commonly aim to achieve positive absolute returns under all circumstances [1]” as opposed to the relative returns framework most mutual funds use.

If investors which to invest in such funds, they will have to buy into the funds with the associated NAV (Net Asset Value) price, which is a value derived from the portfolio of the fund they are investing in.

Management Fees/Expense Ratio (MER)

Management fees are usually the key differentiator when investors compare between the costs of investing into funds. Albeit the associated perks, sometimes, these management fees become quite a bit to handle!

On average, the mutual fund MER ranges from 0.5% – 2.5% [2], where as hedge funds are intuitively placed at a much higher range of 1% to 4% with 2% as standard. Performance fees for hedge funds on the other hand are from 20% commonly but can be up to 50%![3]

Summary

Albeit the thin line of differences between mutual and hedge funds, the profits earned at the end of the day do not lie, and the preference of where to invest ultimately boils down to global events which impact the current economic situation. Nonetheless, the below table[3] summarises the key differences:


Sources:
[1]https://www.morganstanley.com.au/pub/content/dam/msaustralia/resources/pwm/pwm-general-terms-and-modules/hedge-funds-module.pdf
[2]https://moneysmart.gov.au/managed-funds-and-etfs/choosing-a-managed-fund#:~:text=Contribution%20fee%20%E2%80%93%20similar%20to%20an,%25%20and%202.5%25%20per%20year.
[3] https://www.investors.asn.au/education/other-investments/hedge-funds/#fees