How to Compare Investment Funds by Type: Mutual Funds, Hedge Funds, and Index Funds

If you’re like most people, you find yourself taking a greater interest than ever before in the subject of investment planning including the prospects for investment funds. The popular vehicles in the latter category take the form of mutual funds, hedge funds, and index funds.

The main reason for the heightened interest on your part is a growing awareness of the need to take charge of your own financial destiny. With the passage of time, you can see more clearly that you cannot rely on providence alone to take care of the morrow.

New Ball Game in Financial Security

In days of yore, the standard scheme after a lifetime of honest work was to rely on the former employer as the source of a secure income after retirement. Nowadays, though, outfits both large and small have a way of biting the dust in large numbers whether the economy happens to be booming or slumping.

Even if an organization manages to survive the rigors of the marketplace, the pension that it doles out to its erstwhile employees is unlikely to keep up with the ravages of inflation. In that case, the hapless retirees find themselves in dire straits that grow worse with each passing year. As a result, what should have been a comfy retirement in the golden years turns out to be a grinding ordeal that lasts to the bitter end.

In a roily environment subject to endless upheaval, the only way for a saver to ensure a sunny future is to rely on their own devices. For this reason, everyone has to take proactive steps to protect their savings and grow their assets rather than leave it all to chance.

Given this backdrop, the financial forum has taken on an increasing role in the long-range plans of investors throughout the globe. In spite of the expanding interest in the marketplace, however, the path to retirement and prosperity is far from smooth or obvious.

In fact, many folks who amble into the financial arena fall under the thrall of their own impulses as well as the lure of smooth-talking hustlers. As a result, the vast majority of investors find that their portfolios fail to keep up with the benchmarks of the marketplace.

Even when the savers rely on commercial vehicles such as mutual funds, the thrust of the story is the same. More precisely, the league of professional managers trails behind the market averages as well.

Benchmarks Trounce Professionals en Masse

Given the dismal payoff from their own efforts, myriads of investors scrounge around for other ways to improve their results. In a futile effort to outpace the market, a common gambit is to turn to glib operators spouting frothy visions of quick riches. An exemplar of the latter is a hedge fund with a leveraged bet on the fortunes of the stock market.

Wherever they turn, though, the mass the investors end up in the same sad straits. As a case in point, the bulk of mutual funds and hedge funds are unable to keep up with the yardsticks of the forum.

On the upside, however, there is a straightforward way to keep up with the market benchmarks. The latter function is the province of index funds whose express goal is to replicate the benchmarks of the markets.

Given the imperative of preserving wealth rather than squandering it on dicey schemes, the saver ought to approach the task of investment planning in a systematic way. A good place to start is to evaluate the relative merits of the different types of commercial vehicles.

This article spells out a practical approach to fixing up a sound strategy. The key is to pin down the critical features of mutual funds, hedge funds, and index funds.

1. Fathom the Basic Features of the Different Types of Vehicles

Each type of investment vehicle has its characteristic traits in terms of structure as well as function. A quick roundup of the crucial features is as follows.

Index Funds

In line with its moniker, the purpose of an index fund is to match the performance of a market index. While pursuing this objective, the investment pool has to cover a bunch of operating costs such as the transaction fees for trading securities as well as the administrative expenses for salaries and offices. For these and other reasons, the performance of an index fund may differ slightly from the outturn of its target benchmark.

The cohort of index funds is illustrated by a vehicle called the DIAMONDS Trust. The mission of the latter pool is to match the performance of the Dow Jones Industrial Average. More precisely, the goal is to replicate the price action along with the dividend yield for the target benchmark.

In order to cover the costs of running the operation, the stewards of the index fund impose a nominal fee against the portfolio. The going rate for the administrative charge each year is a small fraction of 1 percent of the total assets under management. As an example, the annual tab for the DIAMONDS Trust is about 0.17% of the average value of the portfolio over the course of the year.

Mutual Funds

By contrast to the modest goals of an index fund, the common aspiration of a mutual fund is to beat a specific index of the marketplace. To this end, the caretakers of the fund buy stocks or other assets that they believe will outperform the benchmark of choice.

A mutual fund also levies an annual fee based on the total value of the assets under management. Unlike an index fund, however, the maintenance charge each year could be up to 2 percent or even more of the value of the portfolio.

Hedge Funds

A hedge fund resembles a mutual fund in the sense that its objective is to outpace the market. On the other hand, the hedge fund is a very different creature in terms of the risk for the portfolio as well as the viability of the operation.

More precisely, the operators often resort to chancy schemes such as extreme levels of leverage in a heedless attempt to snag big profits. The upshot is that the outfits have a way of breaking down and blowing up en masse when the market takes a turn for the worse.

Due to the high level of risk involved, a hedge fund is permitted by law to market its services only to wealthy clients. The prospective clients have to demonstrate – or at least declare – that the money they cough up happens to be spare cash whose loss will not affect their lifestyles in a material way.

Another crucial feature of the hedge fund is the usual lack of requirement for the custodians to disclose any details of their activities to the general public. In fact, the outfit can keep mum about the composition of the current portfolio as well as the payoff from past trading.

Under these circumstances, most operators have no incentive to expose their books to public scrutiny. As a result, only the top tier of managers with heaps of self-confidence will have any reason to publicize their performance.

2. Get an Overview of the Performance of Mutual Funds, Hedge Funds, and Index Funds

As an earnest investor, your next task is to seek out a medley of impartial reports on the average performance of different types of pools. The operative word here is impartial.

In many cases, the reports that you come across will take the form of slapdash surveys that were compiled or sponsored by a trade association. On other occasions, the document might be issued by a seemingly independent group. Upon closer inspection, though, you may find that the authors were supported in part or in whole by the very outfits that they were claiming to investigate. Not surprisingly, reports of such ilk leave a lot to be desired.

One of the most common problems in practice is a tally of the high flyers in the forum which is presented as if the outcome were representative of the field as a whole. Looking at the larger picture of the behavior of investors, the evidence suggests that myriads of folks fall for the ruse.

One can hardly draw any other conclusion based on the gross popularity of financial products that underperform the market averages and even collapse in droves whether the overall market happens to be benign or malign. If the patrons had known in advance about the true nature of the game, surely most of them would have stayed out of the arena rather than jump on bandwagons that lead to mass crackups sooner or later.

To compound the problems of patchy information, even an objective study by a solid team can suffer from other deficiencies as well. A prime example of a shortfall is the size of the sample under investigation. In spite of their best efforts, the investigators may find it difficult, or even impossible, to obtain hard data on the entire population of players in the arena.

Another point to keep in mind is the fact that the outcome of one study may differ from another for a number of reasons even if the projects have been pursued in a rigorous fashion. In many cases, the source of variability lies in the focus of the study.

An example of this sort lies in the length of the observation period. For instance, one probe might deal with the performance of the funds over the course of a decade, while a second study might cover a longer stretch.

Yet another cause of variation from one assay to another is the length of the sampling period. As an example, a study that uses monthly data is likely to come up with a different measure of risk than another project that relies on a quarterly tally.

In spite of the differences, though, the potpourri of credible studies tends to come up with conclusions that do not vary a great deal from each other. For instance, the average return for hedge funds reported by one researcher is apt to be comparable to that announced by a different prober for the same class of pools.

3. Understand the Risks of the Different Types of Funds

In the financial arena, the term “risk” usually refers to the flightiness of an asset. More precisely, one rig is said to be riskier than another if its price fluctuates more wildly. We will refer this sort of bogey as chronic risk.

As an illustration, consider two funds named Alpha and Beta. We will assume that both pools are priced at $10 per share at the beginning of the year.

During the first month, the price of Alpha shares rises to $11. On the other hand, the asset crumbles to $9 over the course of February. Then it reverses course and surges to $12 by the end of March.

By contrast, the price of Beta vaults to $13 during the first month. Then the fund crumbles to $8 over the next month, after which it bounces to $12 by the close of March.

In this scenario, the price of Beta was more volatile over the entire period. For this reason, the security is said to be riskier than its counterpart Alpha.

On the other hand, both assets rose from $10 to $12 over the entire span lasting three months. As a result, the average return during this period was the same for the two funds.

In general, investors prefer high gains coupled with low risk. Unfortunately, though, the two traits are usually at odds: higher gains are apt to entail higher risk over the long haul.

Risk of a Wipeout

In addition to the fluctuation in price, there is a big menace that the financial community rarely talks about in spite of its importance. All too often, a basic asset or even a broad-based fund will break down and go bust. In that case, the investors in the rig end up losing their shirts in one fell swoop.

Since the notion of total ruin is a pariah in financial circles, hardly anyone likes to talk about it. In line with conspiracy of silence from the grass roots, there is no terminology for the bugbear that is in general use.

Given its significance to the investor, however, the subject ought to be brought into the open and given its due. In the absence of a suitable term, we will refer to the prospect of death as terminal risk.

Due to the general aversion for the subject, this type of threat is almost always ignored by the statistics of the forum. The omission is especially baleful in the case of a compilation such as the average performance of the “Top 500 Firms” in a particular niche.

To take up an example, suppose that a company or a fund named Gamma were to take on a massive amount of risk. As a result, the punter goes bankrupt during a short-lived swoon of the stock market around the middle of April.

In that case, the index of the Top 500 will ignore the ghastly fate of Gamma. For the compilers of the yardstick, the pretext for the ousting is that the defunct outfit is no longer part of the market.

In this setting, the monthly data for Gamma will end with its price in March, when everything was still hunky-dory. As a result, the statistics will indicate that nothing of substance has happened over the course of the month. More precisely, the value of the yardstick at the end of April will be comparable to that of the previous month.

For the investors in Gamma, though, their net worth tells a completely different story. Anyone who had a stake in the washout would have taken a drubbing in April.

To sum up, the usual statistics of the forum cover only the performance of the survivors. If you happened to own a significant stake in Gamma, then your portfolio would have taken a sound beating. According to the benchmarks of the market, though, all was fine and dandy in the imaginary world pictured by the statistics.

The blind focus on survivors is especially problematic when the rate of mortality is high. As a case in point, the top tier of players in the hedge fund game has an attrition rate of roughly 50% over the course of five years.

Simply put, half of the best performers in the game go out of business within half a decade. We will not even talk about the mediocre players in the arena, let alone the worst punters that die young and never make it into the big leagues in the first place.

Whatever their size, the perennial losers are excluded from the ensemble while the erstwhile pacers are ignored by the statistics as soon as they quit the field. For this reason, the “average performance” that the yardstick purports to track in fact fails to reflect the average outcome for the entire population. Rather, the proxy measures only the average outturn for the players that happened to last the course thus far.

4. Compare the Average Gains Adjusted for True Risk

A high return on average may sound enticing, but it can be nerve-racking if the asset soars and plunges along the way. For this reason, you ought to consider the mean return in relation to the risk due to turbulence.

As noted earlier, the risk factor consists of two parts. One component is the volatility of a vehicle which has thus far survived the rigors of the marketplace. The other aspect is the prospect of a wipeout wherein the fund blows up completely.

If a market index fund does its job properly, then its average return is apt to fall within a small fraction of 1% of the target benchmark. Since the vehicle tracks the index, its volatility will be similar to that of the benchmark as well.

For these reasons, the average return adjusted for risk will be roughly equal to that of the market index. After all, the linkage is the reason for the existence of the fund in the first place.

On the other hand, mutual funds on average underperform the market at large. In addition, a lot of funds of this breed deal with specific niches rather than the entire market.

As a rule, each portion of the market is more tumultuous than the bourse as a whole. Put another way, the volatility of a niche is higher than that of the overall market.

Admittedly, there are a few cases in which a portion of the market can be more sedate than the forum as a whole. A prime example is the utility industry, whose steady dividends ensure that the equities are sheltered to some degree from the wild swings of the bourse at large.

On the other hand, most segments of the forum tend to be more flighty than the overall market. Some of the roughest rides are to be found in cyclical industries such as semiconductors or automobiles.

Given this backdrop, a fund of any sort that deals with a particular niche is more likely than not to be wilder than the broader market. Put another way, the chronic risk is apt to be higher for a focused fund.

To recap, the average return for mutual funds is less than that of the market at large. Meanwhile, the volatility for the mass of pools exceeds that of the broader forum. For these reasons, the risk-adjusted return for mutual funds is on average somewhat less than that of the corresponding value for index funds.

Turning once more to the hedge fund game, the leading tier of high flyers can keep up with mutual funds in terms of gross performance. On the other hand, the net return to investors is significantly lower for a variety of reasons.

One cause of the shortfall lies in the custom of taking a large bite out of any profits that accrue. The standard practice is a cut of 20 to 50 percent of the gross earnings of the pool. Due to the haircut, the investors in a hedge fund end up with a correspondingly smaller take.

In addition, hedge funds tend to pile on a lot of risk and can thus fluctuate wildly in value. Granted, the occasional hedge fund may live up to its name and take a conservative approach to investing. Sadly, though, a sober approach to business is not the usual state of affairs in the financial forum.

Given the fondness for leverage, the volatility of a hedge fund can be gigantic. In that case, the chronic risk turns out to be massive as well.

In line with the foregoing remarks, hedge funds are prone to take on extreme amounts of leverage. For this reason, the punters get pummeled and go out of business in droves whenever the market goes into a nosedive. In other words, the terminal risk for hedge funds as a group is humongous.

Sadly for the patron, though, the risk of going bust does not show up in the usual statistics of the hedge fund sweepstakes. As noted earlier, the yardsticks cover only the outcome of the survivors. Meanwhile, the usual pretense is that the proxy provides an objective measure of performance for the field as a whole.

In reality, the measure is objective only for an investor who happens to know in advance the fate of every single fund during every interval of time. In other words, the gamer can figure out beforehand whether each fund will survive or not over the next period – whether the interval might be a month, a year, or some other span that a given benchmark happens to deal with.

Furthermore, the gamester would also have to be able to close out accounts and transfer funds with impunity at the end of each period without incurring any type of penalty. Otherwise there would be hefty costs associated with the sudden withdrawal of assets from the pools that were about to collapse.

All that is quite a bit to ask for in the real world: perfect knowledge of the future along with zero cost for the sudden withdrawal of funds.

If the investor happens to be a mere mortal, then they will end up betting on the wrong funds from time to time. As a result, the mass of real customers are destined to underperform the “objective” benchmarks of the field.

To round up, hedge funds in general give out less to investors than do mutual funds for a number of reasons. One big factor is the cut taken by the operators as a performance fee any time the portfolio happens to turn in a profit.

At the same time, the free-wheeling pools can be highly risky in terms of the volatility of the portfolios. The same is true of the rate of mortality within the legion of hedge funds.

For these reasons, hedge funds on average trail behind mutual funds by a hefty amount in terms of payout as well as risk. As a result, the risk-adjusted gains turn out to be thoroughly underwhelming.

It’s a good thing that hedge funds are permitted to peddle their services only to wealthy clients. The patrons can afford to give away sizable chunks of their wealth to the operators during profitable spells, then shoulder all the losses when the bets go sour.

From the standpoint of the investor, whether rich or poor, hedge funds don’t seem like such a juicy deal. But then, rationality was never a hallmark of the financial bazaar.

Despite of the glossy models of financial economics spun out by cloistered academics curled up in ivory towers, the rule of logic is not the cause of major moves in the marketplace. Rather, emotion is the primal force that drives the tidal waves surging through the forum.

Moreover, the dictates of impulse play a dominant role in choosing one brand of asset over another. The push of passion is also the motive force when an antsy investor dashes in and out of the market in a tizzy at precisely the wrong times. Punters jump in when they should leap out, and give up when they should step up.

On a positive note, however, there is a simple way to avoid the dismal fate of the majority. The proper course of action for the wily investor is to steer clear of the herd. If you keep your head when all around you are losing theirs, then you’ll doubtless fare better than the rest.

Tips and Caveats for Investment Funds

Further information on investment pools is available in an article titled “Crunch of Hedge Funds”. Although the main focus of the write-up is hedge funds, it also talks about the inability of individual investors to keep up with the market at large. A link to the article is given in the Resources section below.

Another article deals with the past performance and future prospects for hedge funds. The write-up is located at the address indicated below.

Among the raft of curios in the financial arena, one of the poignant features lies in the fact that the average investor lags the market averages. In line with earlier comments, the main reason for the crummy performance is the tendency of punters to leap in and out of the market at the same time as everybody else.

By giving in to their primal urges, investors as a group buy in the throes of a frenzy and sell in the depths of a panic. For this reason, investors are their own worst enemy. We could say that the id is the enemy of profit.

The financial forum is one of the rare fields where you have to unlearn the habits of a lifetime. In contrast to the customs of socialization drilled into you since childhood, you need to go against the grain rather than run with the crowd.

In line with the information in this article, there is a straightforward way to keep up with the market averages with hardly any slippage. The plain tack is to buy an index fund managed by a reputable firm, then go away for a while. In fact, you ought to ignore the market for a prolonged period – preferably half a decade or even several decades at a stretch.

That simple scheme will ensure that you outrun the mass of players in the forum, be they full-time pros or part-time tyros. For the vast majority of investors, the plain approach to financial strategy happens to be the best way to enjoy the boons of investment funds or any other type of asset.

The essence of investing is the relationship between risk and reward. The following video talks about the linkage for the benefit of the novice investor. 

An active approach to investment springs from a desire to beat the market. By contrast, the common goal of a passive scheme is to keep up with the performance of a market benchmark. A pool of the latter sort is also known as an index fund. If the shares of the index fund are packaged in the form of common stock and offered for sale on a stock exchange, the pool also known as an exchange traded fund (ETF). The following video elaborates on these topics; on the downside, though, the clarity of the explanation leaves room for improvement.

John Bogle, founder and former chair of the Vanguard Group of investment products, is a tireless champion of index funds. In an interview, he talks about some of his experiences in the financial arena.

During the financial crisis of fall 2008, John Bogle discuses the problems with the financial system. He notes that the crackup was a symptom of vaulting greed in which speculation was taken to unprecedented heights. Given the emphasis on short-term speculation rather than long-range investment, the general public ends up taking the fall. The winner is Wall Street, which racks up $650 billion dollars a year in fees, commissions and the like. This booty of course comes out of the pockets of the general population of investors.

Legendary investor Warren Buffett recommends index funds in response to a query from the audience on a news program.