Investors looking to diversify their portfolios often consider investing in mutual funds or hedge funds. Although both types of funds attempt to achieve returns by diversifying investments across securities within a portfolio, they take different approaches to doing so. This article will compare the two investment tools and help investors determine which one best suits their needs.
Mutual funds pool money from many investors and invest it in stocks/bonds for the benefit of all shareholders. Investors buy shares (units) in the fund, which trade intraday at market prices like individual securities at any given time during the trading day; no transaction takes place at net asset value (NAV).
Mutual funds can specialize in specific sectors (e.g., technology, healthcare) or asset classes (e.g., emerging markets, high-yield bonds), and close their portfolios to further investment once they reach a certain size. Some funds may have a load, which is a sales charge for entering the fund at the time of purchase. Other mutual funds do not have any fees, so investors only pay a percentage of capital gains when they sell their units in the fund.
Hedge funds are not subject to the same regulations as mutual funds, and this lack of regulation allows them wider latitude in taking on different types of risks and implementing investment strategies. The word “hedge” refers to how hedge fund managers often use short positions which is selling a security one does not own as well as derivative instruments such as swaps and options to mitigate risk exposure and create returns for investors.
Although some hedge funds take long positions, where an investor actually buys a security with the expectation that it will increase in value, their strategies are less transparent to outside investors because they operate with fewer SEC disclosures.
Mutual Funds vs. Hedge Funds
One of the major differences between mutual funds and hedge funds is how they are valued by investors. Mutual fund companies use net asset value (NAV) to determine their current day-to-day price, while hedge funds have marked prices on most days of the month.
NAV creates a price for shares held in each open-end mutual fund based on market values at 4 p.m. the “close” of New York Stock Exchange trading each day while mark prices are determined during the course of all 24 hours and five sessions per week. Since marked prices are determined during the course of the trading day, they may vary significantly from NAV.
Similarities of mutual funds vs hedge funds
Like mutual funds, hedge funds make money by charging fees. However, the structure of these fees can vary significantly depending on several factors including fund strategy, size of fund and the type of investors in the fund.
On average, hedge funds charge an annual fee equal to 2 percent of total assets under management; 20 percent of any realized gains; a “round trip” transaction fee of between 0.5 percent and 1 percent when investors buy or sell holdings within a certain time period after being sold short or borrowing securities without owning them (“shorting”); performance-based fees that range from 10 to 50 percent of profits ; a “gate” fee for redeeming shares during the first few years of the fund’s life and possibly again at the end of that time period; and a flat fee or “management” fee.
Mutual funds are subject to potential loss from market risk as well as other types of risk such as credit risk and interest rate risk. The NAV will reflect changes in underlying investments resulting from those risks accordingly on an ongoing basis throughout the trading day. Investors should note that because mutual funds trade at market prices, the price at which they are sold may be higher or lower than their NAV.
Mutual funds typically report their performance based on a time-weighted basis (TWR or IRR), which does not reflect the actual dollar value gains an investor would realize if he were to buy and sell shares at certain points throughout the year (dollar-weighted rate of return). The higher a mutual fund’s current share price is above its initial purchase price, the higher its dollar-weighted rate of return will be over a given period.
Many hedge funds also use a dollar-weighted basis for reporting performance which in many cases is the only basis available for institutional investors. However, in addition to dollar-weighted returns, each day a hedge fund will list its NAV (market value) to show how it would have performed had an investor initially invested at the official opening price of that trading session.
Mutual funds charge fees based on the amount of money managed by the firm. Some also charge 12b-1 fees for advertising costs and distribution expenses, which can be as high as 0.25 percent annually. Other mutual fund fees include management expenses (a fee paid to an investment advisor or manager typically about 1 percent); shareholder transaction fees (fees charged when shares are bought or sold); and operating expenses (covering accounting, auditing and administrative costs).
Mutual funds are required to disclose their holdings on a regular basis, usually quarterly for common stock investments and monthly for fixed-income securities. Hedge funds are not required to publicly disclose their investment positions because most are private partnerships which are exempt from registering with the Securities Exchange Commission (SEC). However, hedge funds that accumulate more than $100 million in assets under management must report certain information about their portfolio holdings every quarter.
A mutual fund is priced daily after its NAV is calculated. Hedge funds, on the other hand, can be priced intra-day (at any time during the trading day) according to the value of their underlying holdings. Since marked prices are determined during trading and may vary significantly from NAV, mutual fund investments tend to be more liquid than hedge funds.
Performance Tracking and Bench-marking
Since most mutual fund figures are based on time-weighted averages, they are usually presented as indexes rather than absolute values. Indexes provide one of the best ways to gauge the performance of a variety of market sectors and segments. For example, the S&P 500 measures overall performance in the large-cap market segment across all industries including technology, healthcare, financial services and retail.
While both mutual funds and hedge funds pool investment capital from multiple sources, they take different approaches to diversification. Mutual funds are subject to market risk from changes in the value of underlying securities held within a portfolio, whereas hedge funds may pursue a broader range of risks including credit risk and interest rate risk in an effort to produce high returns for investors. As a result, both have their own unique investment considerations that should be considered before making any investment decision.
Frequently Asked Questions
- What is the major difference between hedge fund vs mutual funds?
The hedge fund manager has ability to take decisions whether it is risky or not. On the other hand, mutual fund manager cannot do that.
- Which one is working best in these days?
Hedge funds is not working good in these days while mutual funds performance is good. So, most of the people prefer mutual funds these days.