Often, investors are curious about the differences between hedge funds and mutual funds. Both have similarities in that they make use of diversification to achieve returns and are constructed from pool funds, meaning the funds' capital is derived from multiple investors which is then used by the manager (or managers) for investing in securities that fulfill specific criteria or requirements.

Having said that, there are some marked differences between mutual funds and hedge funds, and those are exactly what we will be discussing in this article.

Mutual Funds vs. Hedge Funds

Some hedge funds have certain requirements that one needs to fulfill before becoming eligible to invest. For example, investors may need to have a net worth of at least $10 million (amounts differ per fund), or perhaps they might require an investor to make an initial high investment to become a participant. Mutual funds, meanwhile, only require a minimum investment and will generally not assess an investor’s net worth.

The associated cost(s) of investment also differs between the two funds. Typically, hedge funds will have greater expenses compared to mutual funds. This is due to the fact that hedge funds not only charge a performance fee, they may also include an expense ratio. For instance, hedge fund fees are often quoted as ‘two and twenty’. This means that they will charge an expense ratio of 2%, in addition to the 20% of whatever profit the fund generates.

Hedge funds can charge these high fees because, as we mentioned, hedge fund investors are generally high net-worth individuals who do not mind paying the extra charges as long as the fee structure has been disclosed up front. On the other hand, mutual funds have a maximum expense ratio of 1%, making them more affordable for average investors.

The performance and objective of the two funds are also major differentiators. Hedge funds will generally give high returns, regardless of the economic environment. However, owing to the largely defensive approach associated with hedge funds, they might not be able to outperform the kind of high returns that mutual funds do during a bullish market.

In other words, a bull market will often see mutual funds making returns in the double digits, while hedge fund returns might be restricted to similar or even possibly lower returns. On the flip side, when the market is bearish, hedge funds will commonly continue to yield a positive return while mutual funds might end up making a loss.