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Difference Between Hedge Funds and ETF

The need for investments can not be underestimated. While people invest with different goals, the main aim is to ensure long term financial security, generate an extra income, save for retirement, and build wealth. There are many investment options available from bonds, hedge funds, stocks, ETFs and even real estate, just to name a few. While some of these terms may be new to some, understanding each investment method and knowing what may work for you is paramount. In this article, we will look at the difference between hedge funds and ETFs. Hopefully, this will guide you in determining which one among the two you should invest in. 

What is Hedge funds?

These are private portfolio investments that use risk investment and management strategies to generate returns. It is open to a limited number of people and is mostly preferred and used by high-net-worth investors. Investors looking to invest in liquid investments should not lean more on hedge funds as they may be required to keep the investments for up to a year. 

Since hedge funds aim at taking advantage of specific identifiable opportunities in the market, they can use investment strategies such as leverage, options and even short-selling. They are open to accredited investors. Since they require a large initial minimum investment amount, only affluent people can invest in hedge funds. 

Characteristics of hedge funds include:

  • They are only open to qualified investors- This is because qualified investors can handle the potential risk that comes with investing in hedge funds.
  • They have a wider investment latitude in comparison to other funds- Hedge funds can invest in anything be it real estate, land, derivatives, currencies and even stocks. 
  • They employ leverage- To enable them make higher returns in a short period, hedge funds can use borrowed capital based on the fund’s strategy
  • They are not registered
  • They work as private investment partnerships
  • They can use different investment and marketing strategies

Despite the high returns, hedge funds have various risks including:

  • They have longer investment periods
  • The use of leverage can cause significant loss from the investment
  • If losses are incurred, they are potentially huge

Investors also ought to pay hedge fund investors an agreed percentage based on the pay structure. In the typical structure, the fund manager receives 20% of profits and 2% of assets each year irrespective of whether profits are made or not. To protect hedge fund investors, fee limitations may be set. This prevents portfolio managers twice on the same returns. Fee caps may also be set to prevent hedge managers from taking excess risk. 

What is ETF?

Short of Exchange Traded Fund, this is a type of security that tracks an index, bond, commodity or a basket of assets. This type of fund is listed and traded on a securities exchange and tracks the returns of a financial instrument it follows. 

By investing in ETFs, an investor’s money is invested in market securities which are part of a predetermined index. ETFs prices are also not constant and may vary throughout the day. This investment is ideal for people looking for more liquid and cost-effective investment options. EFTs could hold one asset or multiple assets, hence being an excellent choice for diversification. 

Types of ETFs include: 

  • Industry ETFs- These track specific industries such as banking, gas sector or banking industry.
  • Currency ETFs- Invest in foreign currencies 
  • Bond ETFs- Includes corporate bonds, local bonds, state bonds and government bonds
  • Inverse EFTs- Uses short-selling to earn profits from stocks
  • Commodity ETFs- Invest in commodities such as gold or crude oil

Investors who choose to invest in ETFs benefit by:

  • Having access to a variety of stocks in many industries
  • Low expenses such as few broker commissions
  • You can choose to target a specific industry
  • You get to manage investment risks through diversification

However, ETFs have disadvantages including:

  • An investor may be limited from diversifying if he invests in single industry-focused ETFs
  • The lack of liquidity may hinder transactions
  • Investors may pay high fees if they invest in actively-managed ETFs

Similarities between Hedge funds and ETF

  • Both are pooled investments to generate returns

Differences between Hedge funds and ETF

Definition

Hedge funds refer to private portfolio investments that use risk investment and management strategies to generate returns. On the other hand, ETFs refer to a type of security that tracks an index, bond, commodity or a basket of assets.

Return

While hedge funds have an absolute return, ETFs have a relative return. 

Management style

Hedge funds are actively managed. On the other hand, ETFs are passively managed. 

Applicable fees

Hedge funds have annual fees whereby the fund manager receives 20% of profits and 2% of assets each year irrespective of whether profits are made or not. On the other hand, fees applicable to hedge funds include operating expenses, trading commissions and ask/ bid spreads. 

Type of investors

While hedge fund investors include high net worth and qualified persons, ETF investors are retail individual investors. 

Liquidity

While hedge funds are illiquid, ETFs are highly liquid. 

Hedge funds vs. ETF: Comparison Table

Summary of Hedge funds vs. ETF

Hedge funds refer to private portfolio investments that use risk investment and management strategies to generate returns. On the other hand, ETFs refer to a type of security that tracks an index, bond, commodity or a basket of assets. While hedge funds have annual fees whereby the fund manager receives 20% of profits and 2% of assets each year irrespective of whether profits are made or not, ETFs have operating expenses, trading commissions and ask/ bid spreads as applicable fees. While both remain viable investment options, investors should not make rushed decisions on which option to pick. 

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References :


[0]Image credit: https://www.picpedia.org/keyboard/images/hedge-funds.jpg

[1]Image credit: https://pixabay.com/photos/mockup-typewriter-word-money-5288033/

[2]Schnusenberg O & Anderson S. Closed-End Funds, Exchange-Traded Funds, and Hedge Funds: Origins, Functions, and Literature. Springer Science & Business Media, 2009. https://books.google.co.ke/books?id=2TQne0GAQrkC&pg=PA80&dq=Difference+between+hedge+funds+and+ETF&hl=en&sa=X&ved=2ahUKEwj4zqfz2_3tAhVOExoKHblyAJ4Q6AEwAHoECAEQAg#v=onepage&q=Difference%20between%20hedge%20funds%20and%20ETF&f=false

[3]Ananth N. Madhavan. Exchange-traded Funds and the New Dynamics of Investing. Oxford University Press, 2016.https://books.google.co.ke/books?id=hZVHDAAAQBAJ&pg=PA3&dq=Difference+between+hedge+funds+and+ETF&hl=en&sa=X&ved=2ahUKEwj4zqfz2_3tAhVOExoKHblyAJ4Q6AEwAXoECAQQAg#v=onepage&q=Difference%20between%20hedge%20funds%20and%20ETF&f=false

[4]Mark Mobius. Mutual Funds: An Introduction to the Core Concepts. John Wiley & Sons, 2007. https://books.google.co.ke/books?id=OCAXVP6Jp_YC&pg=PT36&dq=Difference+between+hedge+funds+and+ETF&hl=en&sa=X&ved=2ahUKEwj4zqfz2_3tAhVOExoKHblyAJ4Q6AEwAnoECAYQAg#v=onepage&q=Difference%20between%20hedge%20funds%20and%20ETF&f=false

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