Hedge funds and mutual funds are partly the same and very different.
The two differ mainly in their investment strategy: mutual fund investors
look for relative returns, while hedge fund investors pursue absolute return
strategies.
Most mutual funds invest in a predefined style, such as “small cap value” or
into a particular sector, such as the oil and gas sector. To measure
performance, the mutual fund's returns are compared to a benchmark. For
example, a fund manager will try to outperform the S&P 500 Index. If the
mutual fund beats the index, even if only modestly, say the index is down 9%
while the mutual fund is down only 6%, the fund's performance would be deemed a
success.
Hedge Funds Actively Seek Absolute Returns Hedge funds are
more active in investing funds to seek positive absolute returns, unmindful of
the performance of an index or sector benchmark. Unlike mutual funds, which
make only buy-sell decisions, a hedge fund engages in aggressive strategies and
positions, such as short selling, trading in options, and borrowing to enhance
the risk/reward profile of their bets.
The active trading strategy of hedge funds explains their popularity when
the market is going down. In a rising (bull) market, hedge funds may not
perform as well as mutual funds, but in a bear market, they do better than
mutual funds because they hold aggressive positions. The absolute return goals
of hedge funds vary, but "6 to 9% annualized returns regardless of market
conditions" is ordinary.Hedge fund investors need to understand that the
promise of pursuing absolute returns means hedge funds are more liberal with
respect to registration, where they invest, liquidity and fees charged.
Hedge funds are not registered with the Securities and Exchange Commission.
They avoid registration by limiting the number of investors and requiring that
investors meet an income or net worth standard. Furthermore, hedge funds cannot
solicit or advertise to a general audience, a prohibition that lends to their
mystique.
Hedge funds are not as liquid as mutual funds and may be difficult to
withdraw anytime. Most hedge funds have a lockout period when investors cannot
remove their money.
Lastly, hedge funds are more expensive and a portion of the fees is based on
performance. Typically, they charge an annual fee equal to 1% of assets managed
(sometimes up to 2%), plus they receive a share – usually 20% – of the
investment gains. Many hedge fund managers invest their own money along with
the other investors of the fund and, as such, have a personal stake in the
fund’s success.