What Is the Difference Between a Hedge Fund and a Mutual Fund?

There are several major differences between hedge funds and mutual funds, from a legal and practical standpoint. Hedge funds have developed a reputation as an investment opportunity only open to the rich. For the most part, this perception is correct. Strictly speaking, a hedge fund is a type of mutual fund in the sense that a group of investors pools funds, and that pool is managed by a professional fund manager to achieve a profit. However, that is where the similarities end.

History

The history of mutual funds can be traced to the early 1800s in the Netherlands, though modern mutual funds as we know them in the U.S. began with the Massachusetts Investors' Trust in 1924. The first no-load fund came in 1928. That was also the year the first stock and bond mutual fund, the Wellington Fund, was born.

The first hedge fund came onto the scene in 1949, launched by Alfred Winslow Jones. He created the fund to hedge his long positions by shorting other stocks. Four years later, he made the fund a limited partnership and began charging 20 percent of the annual profits as a performance fee, a system still in place today.

Function

The function of a mutual fund is to attain a profit within the framework of an explicitly stated investment strategy. For example, the manager of a small-cap growth fund is not allowed to make investing in Treasury bonds the focus of the fund, even if he believes Treasury bonds represent a better opportunity at the moment.

Unlike mutual funds, a hedge fund manager is allowed to invest in anything he thinks might make a profit. If stocks aren't looking good, he might buy real estate or collectible stamps. There really is no limit to what a hedge fund can invest in. Another critical difference is that a hedge fund is allowed to sell stocks short, while a mutual fund is not. In a down market, this gives the hedge fund a huge advantage.

Features

Whereby mutual funds are open to all investors, hedge funds are limited to high-net worth individuals and corporations. Mutual funds can accept a theoretically unlimited number of investors, but hedge funds are limited in the number of investors they can accept in order to maintain their regulatory status. The most unregulated hedge funds are allowed no more than 100 investors, and each of those investors must be worth at least $5 million.

The minimum investment for a mutual fund is generally very low, often $1,000 or even less for qualified retirement accounts. The minimum investment for a hedge fund is usually $1 million. Though a newer breed of funds, called Fund of Funds, aims to invest in several different hedge funds on behalf of lower-net worth individuals, the minimum investment is still $25,000 or more.

The fees involved in mutual funds are quite different from hedge funds as well. Mutual funds charge an annual management fee that is fully disclosed in the prospectus. Hedge funds employ a different system, most often the "2 and 20" system. This means the hedge fund charges a 2 percent management fee plus a 20 percent performance fee on the fund's profits annually. Though management fees can vary between 1 and 4 percent and performance fees can be as high as 30 percent, 2 and 20 is the industry standard.

Size

The U.S. mutual fund market is estimated to be well into the trillions. The hedge fund market is estimated to be about 1/10 that size.

Warning

Since a mutual fund is not allowed to short stocks or participate in futures and other leveraged products, an investor's downside is limited. Due to the heavily leveraged nature of hedge funds, their failures are usually nothing short of spectacular. Some high-profile hedge fund failures like Long Term Capital Management have even required government bailouts.