Trillionaire Term of the Day - January 20, 2009

Hedge Funds vs. Mutual Funds

I have always wondered what the major differences were between hedge funds and mutual funds, so I thought you might have been wondering as well. I have broken down the basic differences into four categories. There are more intricate differences between the two, but this article will provide you with a simple overview.  Enjoy...

Regulatory Requirements

Because mutual funds must register with the U.S. Securities and Exchange Commission (SEC), they are subject to a lot of regulatory oversight.  They are subject to regulation under four different federal laws, and they are also forced to follow a certain standard for portfolio diversification and distribution of earnings.  Hedge funds do not have to register with the SEC, so they are not as regulated as mutual funds are.  They do not have to make forced periodic earnings reports, and they have freedom to invest however they want to invest their funds. 

Fees

Most mutual funds charge a fee of 1.3%-1.5% of assets, and this fee includes a management fee to pay the salary of the fund manager, administrative costs to pay for customer service and record keeping, and the occasional 12B-1 fee which pays for advertising.  The average management fee is around 1% of assets.  This means that if a mutual fund has $250 million in assets (a pretty small fund), the fund manager gets paid $2.5 million a year.  It seems clear that mutual funds strive to get as many investors and as many assets as possible.  Hedge funds have no limits on how much they can charge investors, but the usual hedge fund manager charges 2% of total assets and 20% of gains.  So, while it is much more expensive to invest in a hedge fund, most people do it because they are expecting higher returns.

Investing Practices

Mutual Funds are much more conservative in their investing techniques.  Because they are subject to strict federal guidelines, they are restricted from leveraging or borrowing against the value of the securities in their portfolio.  Hedge Funds, on the other hand, are known for their higher-risk investment strategies. They short sell and conduct options trading regularly, and they can often be highly leveraged. 

Types of Investors

It is easy to invest in a mutual fund, as you must only have the minimum investment (around $1,000) in order to open an account.  Almost anyone can invest in a mutual fund, as the minimum investment is very reasonable and there are no additional investments required after the initial investment.  Investing in hedge funds is much more difficult and selective, as a higher minimum investment is required from hedge fund investors.  Hedge funds require a higher minimum investment because they are only allowed to have 100 investors per fund.  So, if a hedge fund manager wants to control large amounts of money, he can only accept investors who are willing to invest a lot.

Niki Pezeshki

College Trillionaire