What's the Difference Between a Hedge Fund and a Mutual Fund?

By Markets Fool.com

In this segment of Motley Fool Answers, Alison Southwick, Robert Brokamp, and former hedge fund manager Ron Gross break down the variations between mutual funds and hedge funds -- and there are quite a few, most of which are beneficial to the investor.

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A full transcript follows the video.

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This podcast was recorded on Aug. 30, 2016.

Alison Southwick:So, Bro, talk to me a little bit more about what the difference is between a hedge fund and a mutual fund. Is it mostly just the fees and regulatory differences?

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Robert Brokamp:A big part of it is the regulatory differences. So after the Great Depression, a lot of laws were passed to regulate investment companies, and mutual funds have to comply with those. First of all, they do have to file with the SEC. They have to have a board of directors or board of trustees. They have a lot of limitations on how much they can invest in any one security, so they have to be diversified, and they have to be relatively liquid.

Anybody can sign up and invest in a mutual fund. There are no requirements on whether they're a sophisticated investor or not. The minimums tend to be as low as $500. And the fees, while they're not necessarily regulated, tend to be a lot lower, so the average fee on a mutual fund is around 1% or so, and you can get the money out any day the market is trading. So you just put in your order. You don't know what the price of your share is going to be yet, because mutual funds are valued at the end of the day, when the market is closed, based on net asset value, but they are required to give you back your money within a week. And that is also a big difference with that and hedge funds.

Ron Gross:Huge contrast. Hedge funds are not publicly traded, so if you want your money back, you have to submit a letter in writing asking for it back. You could maybe do that quarterly, or semiannually, or even annually, depending on what that hedge fund manager has decided to put in place.

And you're often subject to an initial lockup of one or two years. So you say, "Here's my money. Please go ahead and invest it for me. I understand that I can't ask for it back for one or two years." That's called a lockup, and so you could be subject to that as well. So it's extremely different versus a mutual fund, which is you're basically liquid every day.

Brokamp:Right. How much, Ron, would you say people go into the hedge fund industry because it is more difficult to open a mutual fund? And really they'd be fine running a regular old mutual fund. It's just more difficult.

Gross:It's also the fees. One percent -- you need to have a lot of money under management for 1% to pay all your overhead, all your salaries, and you make the living that you want to make.

Southwick:That's with a mutual fund, typically.

Gross:Yeah. The hedge fund's fees at 2 and 20, that gets lucrative pretty quick, as long as you do a good job.

Southwick:Someone's got to pay for those French cuff shirts. They aren't cheap.

Gross:That's very true. You know, it's interesting. Starting a fund, as we said, is not hard, but raising capital is, and that's because there are so many great or famous, let's say, hedge fund managers out there that capture most of the capital.

Back in my day, hedge funds, to stay on the right side of regulations, weren't even allowed to advertise or market. You kind of had to go out, kind of person by person, explaining what you are, and what you do, and hoping you can get that person to invest. So without the ability to advertise, it made it even harder to get any significant assets under management. Over the years, more recently, those rules have been lightened up on and hedge funds can now market. Whether that's good or bad for the world, I'm not sure, but it's easier to get capital.

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