Wealth Management

Hedge Funds vs Mutual Funds: How to Make Informed Investment Choices

By April 14, 2020 No Comments

People talk so about stock markets that it’s easy to forget how vast securities markets are if you were to combine them all. There are many ways to review the performance of major US exchanges because they are measurements of different classes of companies, financial markets, and industrial sectors.

Many more securities are being traded than just stocks. Most of the trading activities that we observe occur in secondary markets. Secondary markets are just securities that have been resold. Prime brokers are responsible for managing IPO stocks as well as new pools of stocks that companies want to open to the public. Hedge funds, on the other hand, are not publicly traded. They are based on the performance of securities underlying the funds. For that reason, fund managers watch industrial sector activities very closely. That can vary, however, depending on the hedge fund strategy.

How do hedge funds work?

Most hedge fund strategies involve a combination of “puts” and “calls,” and trades take place through derivatives. The two forms of derivatives are swaps and options. Swaps require you to trade and options are, well, an option to make a trade. If a fund manager’s strategy is a long position, it means they expect the stock price to increase. Multiple strategies involve long-only positions. “Shorting” a stock position means the trading desk expects a company’s stock to lose market value.

“Puts” give the contract holder the right to purchase a security and, alternatively, “calls” grant the right to sell securities under an options contract. Contracts do have restrictions on how they are used. They are only good for the numbers of shares written into the contract and they expire. Therefore, timing is critical to the successful execution of a strategy. Hedge funds are “closed-end” funds.

When they seem similar vs. what makes them fundamentally different?

Mutual funds are “open-end” funds and a bit more straightforward. They are easy to track because they have tickers. Bond and equity mutual funds trade daily, which makes them a much more liquid asset as compared to a hedge fund. You can only buy into a hedge fund once monthly and must hold it over a period of years to not incur a penalty.

Hedge funds require a signed, long-term commitment and a schedule of fees. Hedge funds vs mutual funds do have higher returns when the fund develops a proprietary model that becomes successful. Together they should make up a big part of your overall portfolio asset allocation with a mix of money markets, stocks, and other fixed-income products.

Layered diversification strategy

One thing to remember is that both hedge funds and mutual funds can carry debt or equity as an underlying asset. People erroneously think of hedge funds as equity products when, in truth, many strategies are based on credit and fixed income market returns. Some wealth managers might recommend that your investment strategy contains a layered diversification approach. For example, it’s a good idea to diversify with both equity and fixed income-based mutual funds.

When it comes to hedge funds vs. mutual funds, consider multiple strategies if you have the investment capital. Investopedia has published a list of those strategies:

  • Long/Short Equity
  • Market Neutral
  • Merger Arbitrage
  • Convertible Arbitrage
  • Event-Driven
  • Credit
  • Fixed-Income Arbitrage
  • Global Macro

Don’t ever feel like you need to invest in all of these hedge fund strategies to achieve a well-diversified portfolio of assets.

Mutual fund strategies all contain long-only positions, meaning the goal is to sell their units in the future at a profit based on yield from debt instruments, stock dividends, and per-unit price gains on both. They are described in these broader categories below:

  • Growth funds
  • Value funds
  • Index funds
  • Blend funds

Ideally, aim towards having investments from various asset classes in your portfolio which are both US and non-US in origin. This is another good topic to bring up with your wealth advisor.

Wealth management strategies

Before making any investment decision, consult with a registered investment advisor (RIA). Class “A” advisors not only abide by securities regulations and ethical standards as finance professionals, they have a holistic approach to helping you find the best investment solutions overall. SD Mayer has decades of experience in wealth management, taxes, accounting and other financial services. The fully-staffed office is located in the financial district in San Francisco but they serve the greater San Francisco Bay area and can help you determine the best wealth management strategies for your unique, individual financial situation.

SD Mayer’s wealth managers have decades of experience, and if you have questions about hedge funds vs mutual funds, they can help you find the answers. Contact us today to set up an initial consultation.

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