How Are Mutual Funds, Hedge Funds, and Index Funds Different?

There are two ways to invest. The first approach is that you go solo and invest in individual securities on your own. The second approach is that you invest through pooled investment vehicles. You basically outsource the job to an investment manager. ETFs, REITs, mutual funds, index funds, and hedge funds are popular pooled investments. So, what should you choose for your portfolio?

An index fund is a passive investment strategy. The fund manager tries to replicate the returns of the underlying index. In contrast, a mutual fund is an active investment strategy. The fund manager takes active investment calls with the objective to outperform the benchmark index. The fees in an index fund are lower compared to other actively managed mutual funds.  

Active fund managers have consistently underperformed passive funds. According to SPIVA (S&P Indices Versus Active Scorecard), 71 percent of large-cap fund managers underperformed the S&P 500 last year, which marked their tenth consecutive year of underperformance. In 2019, 68 percent of mid-cap fund managers underperformed the S&P MidCap 400, while 62 percent of small-cap fund managers underperformed the S&P SmallCap 600 Index.

Passive investing has gained popularity over the last decade. Active funds haven’t been able to beat the index despite charging higher fees. In a tectonic shift in August 2019, the assets under passive investing surpassed those under active investing for the first time ever. While the assets of passive funds like index funds and ETFs have been gradually rising, many see it as a risk to financial stability. 

Last year, Michael Burry, whose famous and profitable bet against collateralized debt obligations (CDOs) featured in the best-selling book The Big Short: Inside the Doomsday Machine and the film adaptation The Big Short, compared the massive inflows into index strategies to the bubble in CDOs that eventually burst and triggered the Great Financial Crisis. 

Hedge funds and mutual funds are actively managed. However, there are several differences between the two including regulations. Hedge fund regulations are much less stringent than mutual funds. Hedge funds can make some high-risk investments that a mutual fund isn't authorized to make. Generally, hedge funds are meant for sophisticated investors who understand the high risk. Mutual funds are available to all investors. 

Unlike mutual funds, which strive for relative outperformance over the benchmark, hedge funds strive for absolute returns. There's a difference between hedge funds' and mutual funds' fee structure. While mutual funds only charge a management fee, hedge funds also charge a performance fee that is based on the returns generated. Historically, hedge funds have performed better than mutual funds.

If you are a retail investor with little knowledge of investing and you want to maintain a hands-off approach, you should consider index funds. Even Warren Buffett talked on similar lines in this year’s annual shareholder meeting. If you can devote a little more time to your investments, you can add some mutual funds along with index funds. If you are a sophisticated investor chasing higher absolute returns and are comfortable with high risk, you can choose from the best hedge funds.