Difference between a Hedge Fund and a Mutual Fund

February 3, 2017 by Editorial Team

In the competitive world of corporate finance, two types of funds are the hedge fund or the mutual fund. While they share a few basic principles, they are not the same and not to be used interchangeably. This article will explain their differences.

Definitions

A hedge fund is a pooled investment vehicle which only caters to big or wealthy investors (e.g. institutions, individuals with substantial assets). Currently, the US Securities and Exchange Commission do not regulate hedge funds. This distinct feature allows a hedge fund to be managed with a greater level of flexibility.

While it can invest in traditional securities (e.g. stocks, bonds, real estate, commodities), a hedge fund can take positions in a broader and sophisticated (often risky) range of investments. A common investment technique used by hedge funds is called a long-short strategy. Taking a long position is simply buying stocks. A hedge fund can also borrow a stock (i.e. short position) from a broker, sell it, and make money by buying it back when its price goes down. Hedge fund managers also practice what is called “leveraging,” an investment technique that involves investing with borrowed money. Leveraging is an aggressive strategy that can drastically increase return potential but can also be risky.

Hedge fund shares are difficult to sell as they take time to generate gains because of the lock-up period. Thus, investors cannot sell shares during this set period of time. Hedge fund managers get a percentage of the gains they generate for their investors. This is on top of the management fee they are entitled to, which is usually a small percentage of the fund’s net asset value. This often leads fund managers to become too bold in their investment strategies, thereby increasing investor risk.

mutual fund
Investing in mutual funds is saving for the future

A mutual fund is a trust where funds are pooled from various individual investors. These funds are aggregated with the objective of investing in stocks, short-term market instruments, bonds, other assets and securities, and combinations of these investments. These assets and securities make up a mutual fund’s portfolio, which is managed by an investment adviser accredited by the SEC (Securities and Exchange Commission).

In the US there are three variations of mutual funds; namely, open-end funds, closed-end funds, and unit investment trusts. Mutual funds are typically applied in open-end funds where shares are bought back from investors each business day. American investors usually put their money in open-end funds in preparation for retirement or for other financial goals.

Investors in mutual funds purchase shares directly from the mutual fund. Shares can also be bought from investment professionals such as brokers. Mutual funds are required to price their shares every business day, and this is typically done after the close of major US exchanges. This price is the mutual fund’s per share value minus its liabilities, designated as the net asset value or NAV. This is the per-share price mutual funds use to sell and redeem shares with, calculated after the investor makes a purchase or a redemption order. In other words, an investor who places an order for mutual fund shares during the trading day will not get the purchase price until the next NAV is determined.

Comparison

One major difference between these two investment vehicles is that hedge funds are not regulated by the US Securities and Exchange Commission. This allows hedge fund managers greater flexibility in investment strategies. However, hedge funds are governed by the same prohibitions against fraud. Mutual funds, on the other hand, are SEC-registered and abide by its restrictions. Thus, a mutual fund manager is expected to adhere to the strategy prescribed by the fund. Mutual fund investments are limited to just a number of investment types.

Most hedge funds charge performance-based fees. That is, if the fund performs well in the market, investors are required to pay higher fees. In contrast, mutual funds charge specific amounts that are capped by the SEC. Hedge funds seek long-term investments that do not give quick returns, thus it is difficult for investors to sell their shares early. On the other hand, mutual funds have a per-share price that is determined daily so investors can sell anytime.

Comparison Chart

Hedge FundMutual Fund
Not regulated by the US SECRegulated by the US SEC
Charges performance-based feesCharge fees set by the SEC
Shares cannot be sold within a specific periodShares can be sold anytime

Video

Here’s a YouTube video detailing the differences between hedge funds and mutual funds.