Hedge Funds, Mutual Funds and Index Funds - What's the Difference?

One of the best wealth building strategies is the stock market.

Since I've started getting involved in the market, I noticed that most people are very intimidated by it. There is so much to learn and comprehend and most people stay out because it is easier to avoid than to learn. This is a huge mistake. After you learn a few principles, the market becomes interesting, exciting and profitable.

Now, I am no day trader. I have no interest in using the market as a stream of daily income. I'm not there yet, so I play the long game. I'm really just a baby at this, but I am learning and I am enjoying the ride.

One of the strategies that has peaked my interest is investing in different kinds of funds. Again, I see a lot of instances in which people are already confused and intimidated by it and so they don't get in.

In this article, we will discuss what funds are and I will explain in plain English the different kinds of funds so you have a better understanding of how it works. I invite you all to get into the market and start preparing for your future.

Before We Get Started, What On Earth is a Fund?

When I google "What is an investment fund", this is what I find.

An investment fund is a supply of capital belonging to numerous investors used to collectively purchase securities while each investor retains ownership and control of his own shares.

IN ENGLISH PLEASE!!!

A fund is a pool of money. People put their money together into a big pot or a fund. At which point a fund manager can use that money to invest in different stocks, bonds or other investments. So instead of you managing your entire portfolio by yourself, you can put your money into a fund and (for a fee) have your money managed.

A fund is...

• a great way to diversify, as you only need to put your money into a fund and through that, your fund manager will allocate it to different investments.

• a great way to minimize risk, as your money is spread through different types of investments, protecting you from a crash.

• a great way to get involved with the market without dedicating all your time as your allocation of assets will be on your fund report.

Simply put, funds are a safe, long-term strategy that can help you build retirement and increase your overall net worth.

Okay, so we know what a fund is, but of course, it's not that simple. There are different kinds of funds which are important to know as well.

What is a Hedge Fund?

A hedge fund is a private fund available only to big shots. You must have a high net worth to get involved with a hedge fund. The fund managers have complete flexibility to bet on both sides of the market (up and down). Typically, they charge a 2% management fee and they also share in the profits which is usually a 20% cut.

Hedge fund managers are very active in the market. It's about leveraging other people's money to bring in the highest return possible. But these returns come in different ways.

Hedge funds are not subject to the same regulations as mutual funds and because of this, it can be a lot harder to understand where your investments are located, or even how they are doing. Hedge funds are volatile.

However, many people are still eager to invest in hedge funds. The reason being that hedge funds are a way to add an additional element of diversification beyond stocks and bonds. They do this by employing “alternative” strategies that can include everything from short-selling stocks to taking large positions in companies and actively influencing change.

If you are looking for some context, Bobby Axelrod from the Showtime TV show Billions manages a hedge fund. (Because you know... everything is exactly like we see it on TV)

What is a Mutual Fund?

A mutual fund is similar to a hedge fund in that it is a pool of money from a multitude of investors. Again, the fund is managed by a fund manager but in this case, a mutual fund is open to anyone. In most cases, a mutual fund is handled my a team of managers who assembles a portfolio of different stocks, bonds or other assets. The team works on the funds behalf to try and "beat the market" or turn a profit.

Mutual funds are a great starting point, for someone who has a few thousands dollars to invest, you can get your feet wet with a mutual fund and slowly add more capital into the fund.

Again, you will have the benefit of an ongoing manager (or team) to keep track of the fund and send reports giving you information of the progress of your investments. You can set it up to automatically re invest dividends or profits, which is a good idea if you are looking to take advantage of substantial growth.

But wait! There's a catch.

Just like a hedge fund, there are a lot of fees to be aware of. Because a mutual fund isn't as aggressive as a hudge fund, the fees and the profit shares are not as drastic. However, there are fees that can really cut into your earnings. With compounding, those feeds can really add up.

As I said before, mutual funds are a great place to start your investment career, but do your research and find all the hidden fees involved with each particular mutual fund.

Index Funds

Index funds are my favorite, but index funds are only useful if you are committed to keep your money in the market over a long period of time. I'm talking decades.

Index funds are funds that are not "managed" but rather dump money into a certain market index to match the returns on the market.

Here is the best way to understand it.

Index funds are not "actively managed" but rather passively managed, meaning they are not analyzed and manipulated to try and time booms and get out of busts to essentially beat the market. An index grows consistently with the overall growth of the market index.

So for example, let's say you invested in the S&P 500 index, that means that you would simply own stock in those 500 companies, and rather then switch back and forth from different stocks and bonds, your money would grow with the growth of that index.

So unless you're a superstar market analyst, you're better off capturing the market return as opposed to trying (and most likely failing) to beat the market.

Even better, index funds charge very minuscule fees (since there is no one managing the fund) that can save you a fortune over the long run.

The Tricky Part of Index Funds

Simply put, the aspect of index funds that gets screwed up is us. It is emotion.

If you analyze the index market over the last 100 years or so, you will see that it almost always goes up. There is almost always a return, but in order to see returns in the long run, you need to have the stones to leave your money in the game during bear markets.

Even better, maybe put your money in during bear markets. Now were talking.

The point I am trying to make is that as human beings, we rely on emotions to guide our decision making. But the vast majority of the time, our emotions create fear and fear creates impulse. Leaving your money in the market (for at least ten years) is a must if you are looking to pull real returns on index funds.

Hey... Let's Chat

Investing is still very new to me. Over the last two years I have pulled a 7.2% return on my investments and I feel pretty good about what I've learned so far.

I've learned not to be over confident and not to let bull markets convince me that I am an expert investor. I am humble enough to know that there is still so much for me to learn. If you see anything in this article that you believe to be inaccurate or maybe you wish to clarify something, please do so in the comments section below.

I look forward to hearing your response and I hope you join me in the journey of personal finance and investment.

Never settle