Mutual funds and hedge funds both invest in variety of stocks and bonds. Both types aim to make money for their investors, but some individual funds are more inherently risky than others. Before investing in either mutual funds or hedge funds, be sure you understand how they operate and the potential downsides.
Mutual Fund Basics
Mutual funds are registered with the U.S. Securities and Exchange Commission and must make periodic reports of their activities. As such, they are subject to reporting rules and government oversight. Mutual funds trade at the close of the market day and make straightforward buy and sell transactions. They invest in all types of investments, such stocks, bonds, commodities and real estate.
Hedge Fund Basics
Hedge funds are not required to register with the SEC or to submit period reports While mutual funds are offered publicly, hedge funds are private offerings. Many of them are “hedging” bets against downturns in the markets, hence their name. They invest in a variety of ways, some of which you could politely call “creative.” These exotic investment tools include leverage, derivatives like options and futures, and short sales.
If these words are all Greek to you, you're not alone. In a tiny nutshell, they are tricky financial instruments that allow investors to speculate on future prices or allow purchasing on credit. The purpose of hedge funds is to bring high returns despite risk, but some are less volatile than others.
Minimums and Fees
One critical difference between mutual funds and hedge funds is the minimum investment amount. The average mutual requires only a small up-front investment, as little as $1,000 or an automatic purchase plan of $50 per month. Hedge funds generally require much larger investments, typically a minimum of $100,000 or $1 million.
Mutual funds have modest management fees, approximately 1 or 2 percent per year. Hedge funds also charge about 2 percent in annual fees but also command a “performance fee” of 20 percent or more of any increase in the fund's value. They get away with these fees with the understanding that they hire the top financial minds in the world and aspire to offer spectacular returns.
Risks and Rewards
Mutual funds and hedge funds both offer diversification because their portfolios consist of a mix of investments. In either case, you relinquish control of selecting individual equities or bonds, leaving those decisions to professional fund managers. Some mutual funds are quite conservative, while others are rather risky. Greater risk brings more potential for high returns, and there are so many funds to pick from that you're bound to find many that match your level of risk tolerance.
Funds of Hedge Funds
There's really no such thing as a conservative hedge fund, but you minimize the risks somewhat by investing in a fund of hedge funds rather than a single fund. Funds of hedge funds also require smaller minimum investments, sometimes as low as $25,000. You will have to pay two layers of fees, one to your fund of funds and then indirectly to the funds it holds.
Annabella Gualdoni has written newsletters and reports for corporations and nonprofits since 1994. She is a real estate professional and also teaches subjects including international cooking and travel, dating/relationships and personal finance. Gualdoni has a Bachelor of Arts in international development from University of California, Berkeley, a Master of Arts in international relations from Boston University, and a Juris Doctor from Boston College Law School.