Hedge Funds vs. Mutual Funds: What’s the Difference?
Hedge funds promise high returns, but do they really outperform mutual funds? Get the facts on fees, risks, and returns before you decide.
When it comes to growing your wealth, it’s all about understanding which investment vehicles to use. You’ve likely heard of mutual funds and hedge funds, two of the most popular investment options. But here’s the catch: while both involve pooling money from multiple investors to generate returns, their strategies, risk levels, and costs couldn’t be more different.
Did you know that in 2023, the average hedge fund return was about 8%? That same year, the S&P 500 index—a common benchmark for mutual funds—returned over 24%. Despite the promise of higher returns, hedge funds often fail to consistently beat the market, especially once high fees are factored in.
Choosing between hedge funds and mutual funds isn’t just about returns—it’s about finding the right fit for your financial goals, risk tolerance, and investment timeline. Let’s break down what sets them apart so you can make a more informed decision about where to put your money and why it matters for your future.
What Is a Hedge Fund?
Think of a hedge fund as an investment partnership that is mainly for wealthy individuals and big institutions. Hedge funds typically use aggressive, sometimes complicated strategies to aim for high returns.
Hedge funds are also usually managed by experienced portfolio managers who use methods like short selling (betting that a stock will lose value), borrowing money (leverage), and financial tools like derivatives (contracts whose value depends on underlying assets) to try to beat the market or protect against losses.
That’s where the name comes from: Hedge funds are designed to "hedge" against market downturns. In reality, though, they often chase high returns.
Here's what you should know about hedge funds:
Exclusive Access: They usually require large initial investments (often $1 million or more) and are open only to accredited (high-net-worth) investors.
Less Regulation: Hedge funds don't face as many rules from the SEC, giving fund managers more freedom in their investment decisions.
Aggressive Strategies: Managers might use leverage (borrowed money), invest in derivatives, or take positions in global markets.
High Fees: Most hedge funds charge a “2 and 20” fee structure. This means they take 2% of assets under management plus 20% of any profits earned.
Because of the high risk and complicated nature of hedge funds, they generally aren't considered the best choice for everyday investors. They are considered too volatile and are meant for people who can comfortably take big risks in hopes of big returns.
What Is a Mutual Fund?
A mutual fund is an investment option available to just about anyone. It pools money from everyday investors to buy a variety of assets like stocks, bonds, and other securities. Mutual funds are popular because they're straightforward, affordable, and heavily regulated to protect investors.
You can usually start investing in a mutual fund with as little as a few hundred dollars. They’re available through most online brokerages and retirement plans.
Key features of mutual funds include:
Low Barriers to Entry: You don’t need to be a millionaire to invest. All you need is a standard brokerage account or retirement plan like a 401(k).
Diversification: Mutual funds often hold dozens or even hundreds of securities, which helps reduce your overall risk.
Transparency: Mutual funds are required to disclose their holdings, performance, and fees regularly.
Regulation: They're governed by the Investment Company Act of 1940, which protects investors through standardized rules and reporting.
Fees: Mutual fund fees vary, but many low-cost index funds charge as little as 0.03% annually.
Because of their simplicity, affordability, and built-in diversification, mutual funds are one of the most popular investment vehicles for retirement savings and long-term wealth building. Whether you’re investing in a large-cap stock fund or a bond index fund, there are options for almost every risk tolerance and investment horizon.
Do Hedge Funds Perform Better Than Mutual Funds?
In a hedge funds vs. mutual funds battle, many people may automatically assume that hedge funds will come out on top. But is that really true?
Despite their high fees and complex strategies, hedge funds don’t always outperform mutual funds. In fact, over the past decade, many hedge funds have struggled to beat the market, especially after accounting for fees.
According to data from Preqin, the average hedge fund returned around 10% in 2023, while the S&P 500, a common benchmark for mutual funds, returned over 24%.
Here are a few factors that affect performance.
Risk vs. Return
Hedge funds often take on more risk in pursuit of higher returns. Sometimes, it pays off, but it can also lead to big losses. Mutual funds, particularly index funds or target-date funds, are built for long-term stability, not short-term gains.
Fee Structures
Even though the “2 and 20” hedge fund fee structure seems small, it can eat away at returns quickly.
Let’s say you put $5,000 into two different funds, each earning an average annual return of 8%.
Fund A charges hedge-fund-style fees ("2 and 20"). Every year, they take 2% of your total investment plus 20% of your annual profits.
Fund B is a passive mutual fund charging a low annual expense ratio of 0.1%.
After just one year:
Hedge Fund A grows your $5,000 by 8% ($400), bringing you to $5,400. But then come the fees:
Annual management fee (2% of $5,400): $108
Performance fee (20% of the $400 profit): $80
With Fund A, you’re left with $5,212 because the fees are so high.
Mutual Fund B also grows your $5,000 by 8% ($400), bringing you to $5,400. Its fee is just 0.1% ($5.40), leaving you with about $5,394.60.
That's roughly $182.60 lost to fees after just one year. Over many years, losing even a seemingly small amount annually can add up quickly, leaving you with significantly less money in your account.
Market Conditions
Hedge funds often promise exciting results, especially in volatile or declining markets. Their strategies can actively benefit from economic shifts, like currency swings or geopolitical events.
Meanwhile, mutual funds tend to follow the overall market trends more closely. So, depending on what's happening in the economy, one type of fund might outperform the other.
For example, a hedge fund using a global macro strategy might capitalize on something like a sudden currency change, which mutual funds typically don't actively pursue.
Investor Access
Mutual funds are made for everyone. They're accessible, straightforward, and designed to consistently track a specific benchmark or investment strategy.
Hedge funds, though, usually aim to beat the market, using complex strategies. While that can sound appealing, many hedge funds don't actually outperform mutual funds, especially after considering fees and risks. In fact, when you look at the numbers, mutual funds often come out ahead, particularly after adjusting for risk.
Bottom line: Performance will always vary, but there's no guarantee a hedge fund will deliver better results than a solid mutual fund, especially once fees and risks are considered.
Curious to see more performance data for yourself? Check out research from reputable sources like Morningstar to see how different types of funds have historically performed.
Choosing Between Mutual Funds and Hedge Funds
Choosing between hedge funds and mutual funds comes down to your financial goals, risk tolerance, and investment access.
Consider a hedge fund if:
You’re an accredited investor with a high net worth
You’re OK navigating complex strategies and potential losses
You want access to unique investment opportunities
A mutual fund might be a better fit if:
You’re just starting out with investing.
You want a low-cost, diversified portfolio.
You’re focused on long-term, steady growth.
For most people, mutual funds (especially index funds) are typically the smarter, simpler, and more effective route to building wealth over the long term. Hedge funds might sound intriguing, but they're rarely necessary unless you're prepared for higher risks and have access to elite fund managers.
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Hedge Fund Vs. Mutual Fund FAQ
1. Which is better for long-term growth: hedge funds or mutual funds?
Mutual funds tend to be a better choice for long-term, steady growth due to their diversification and low fees. Most mutual funds, especially index funds, track the broader market, making them less volatile and ideal for investors with a long-term perspective. In contrast, hedge funds often focus on short-term gains through riskier strategies, which can be inconsistent over time, especially when factoring in high fees.
2. How do hedge fund fees affect my returns?
Hedge funds typically charge high fees, often a "2 and 20" structure (2% of assets plus 20% of profits). These fees can quickly eat into your returns. For example, on a $10,000 investment, if your hedge fund makes a 10% return ($1,000), you would pay $200 in management fees and $200 in performance fees, leaving you with just $600 instead of the full $1,000. Over time, these fees can significantly reduce the potential growth of your investment.
3. Can mutual funds lose money like hedge funds?
Yes, mutual funds can lose money, just like any investment, especially if the market experiences a downturn. However, because mutual funds typically focus on diversification (spreading investments across many stocks or bonds), they are generally less volatile than hedge funds. Hedge funds, on the other hand, often use aggressive strategies that carry higher risk, making them more susceptible to larger losses during market fluctuations.
4. Are hedge funds accessible to everyday investors?
Hedge funds are generally not accessible to everyday investors. They require a high minimum investment, typically around $1 million, and are usually open only to accredited investors (those with a net worth of $1 million or more, excluding their primary residence). Mutual funds, however, are accessible to most people with much lower initial investment amounts, sometimes as low as $100 to $1,000.
5. How do hedge fund strategies differ from mutual fund strategies?
Hedge fund strategies are often much more aggressive and can involve things like short selling, leverage, and derivatives to generate high returns. These funds aim to outperform the market, sometimes by betting against stocks or using borrowed money. Mutual funds, on the other hand, typically follow a more conservative approach by diversifying investments to reduce risk. Many mutual funds, especially index funds, aim to replicate the performance of a market index (like the S&P 500) rather than beat it.