Hedge funds, mutual funds or index funds: Finding the right fit for your client

Find out the characteristics of each of these funds

Hedge funds, mutual funds or index funds: Finding the right fit for your client

In today’s marketplace, a wide range of investment vehicles is available for Investors to choose from, but not all those choices will fit their needs and goals. In this article, we will take a close look at three popular types of investment funds: hedge funds, mutual funds, and index funds.

What are mutual funds, index funds and hedge funds?
Hedge funds are offshore investment funds formed as private limited partnerships engaging in speculations using credit or borrowed capital. They explore every available market and use various investment strategies and financial instruments. They can be very volatile, with much risk involved and profit margin.

Mutual funds are professionally managed investment vehicles funded by various shareholders who trade in diversified holdings; they are a collection of stocks and bonds. Investing in them generates capital gains. With mutual funds, investors can choose the stock and bond they want to invest in, as well as invest in global funds, sector funds or regional funds. Unlike hedge funds, they are less volatile, highly regulated and sold to the general public.

Index funds are mutual funds or exchange-traded funds (ETFs) intended to track the returns on investment of a market index. Compared to both hedge funds and mutual funds, they are less complicated and charge fewer administrative fees. However, they have lower turnovers and include the possibility of generating tracking error in a failing market.

What are their average fees?
In the hedge fund industry, the typical fee structure is known as “2 and 20.” It means that investors will pay 2% of their assets in management fees (regardless of the funds’ performance) plus 20% of their profits in performance fees. While some funds are justified in these fees, negotiating them downwards is worth trying. One option is to opt for a fee structure with lower management fees but makes up for it by charging a higher performance fee.

When investing in mutual funds, investors may pay varying one-time sales charges, ongoing management fees and other transactional costs and account fees charged by the fund company, depending on which funds they buy, how they buy those funds and what accounts they hold those funds in. Below are the top costs, according to GetSmarterAboutMoney.ca:

  • Sales charges: Also known as loads, investors may pay sales charges when they buy or sell units or shares of a fund. These sales charges have four types: front-end load/initial sales charge (up to 5% of the amount invested in the fund), back-end load/deferred sales charge (up to 6% upon selling units or shares), low load (up to 3%) or no load.

  • Management fees and operating expenses: These make up the fund’s management expense ratio (MER). They are paid by the fund and expressed as an annual percentage of the total value of the fund. The MER can range from less than 1% to more than 3%. While investors do not pay these expenses directly, these expenses reduce the fund’s returns.

  • Trailing commissions: Most mutual funds pay a trailing commission each year to the company that sold the fund to an investor for as long as the investor holds the fund. The rate of the commission is set by the fund company, typically ranging from 0.25% to 1.25%.

In contrast, index fund managers trade holdings less often, incurring fewer transaction fees and commissions. As a result, index funds often cost only between 0.2% and 0.5%, with some firms offering even lower expense ratios of 0.05% or less.

What is considered a low and high expense ratio?
Expense ratio is the amount that companies charge investors to manage a fund. It is calculated by dividing a fund’s operating expenses by the average total dollar value for all the assets within the fund. A low expense ratio is generally considered to be around 0.5% to 0.75% for an actively managed portfolio, while an expense ratio greater than 1.5% is considered high.

Several factors determine whether an expense ratio is high or low: the category of investments, the investment strategy used and the size of the fund. A fund with a smaller number of assets typically has a higher expense ratio due to its limited fund base for covering costs.

Fund expenses can make a significant difference in investor profitability. If a fund realizes an overall annual return of 5% but charges expenses that total 2%, then 40% of the fund’s return is offset by fees. Thus, investors should compare expenses when researching funds. Investors can find a fund’s expenses in a fund prospectus or on financial websites.

As index funds have become popular, they have encouraged lower expense ratios. They replicate the return on a specified financial market index. This type of investing is considered passive, and portfolio managers buy and hold a representative sample of the securities in their target indexes. Index mutual funds also tend to have lower expense ratios because they focus on large-cap blend funds that target large-cap indexes, according to Investopedia.

What are the differences between active and passive management?
Active and passive management are the two main investment strategies that investors can use to generate a return on their investment portfolio. They differ in how the manager uses investments held in the portfolio over time.

Investors implementing an active management approach use fund managers or brokers to buy and sell stocks in an attempt to outperform a specific index. An actively managed investment fund has an individual portfolio manager, co-managers or a team of managers making investment decisions for the fund. The fund’s success depends on combining in-depth research, market forecasting, and the experience and expertise of the portfolio manager or management team.

Passive management, also known as index fund management, involves creating a portfolio intended to track the returns of a particular index as closely as possible. Its purpose is to generate a return similar to the chosen index. This strategy does not have a management team making investment decisions and can be structured as an ETF, a mutual fund or a unit investment trust.

Whichever fund and management strategy investors choose, their decision should reflect their investment philosophy and help them achieve their financial goals.