Hedge Fund vs. Private Equity: Pros and Cons - SmartAsset

Hedge funds and private equity are investment vehicles that are designed to appeal to high-net-worth investors. They can both offer higher return potential than investing in stocks or traditional mutual funds, though they can also carry more risk. While they share some similarities, there are several things that set them apart. The most significant differences between hedge funds and private equity center on their underlying investment strategy, liquidity and cost. A financial advisor can help you sort through if either private equity of hedge funds would be a good fit for your portfolio.

Hedge Funds, Explained

A hedge fund is an investment vehicle in which funds from multiple investors are pooled together. These funds are typically designed with a single purpose in mind: To produce the highest returns possible for investors.

Hedge fund managers are responsible for the decision-making part of that equation. A hedge fund manager is a highly skilled individual, often a chartered financial analyst (CFA), who uses his knowledge and expertise to manage the fund’s investments.

These funds can employ specific strategies to achieve their objectives and deliver returns to investors. For example, a hedge fund may specialize in commodities trading or real estate. Or it may go long or short with stocks from certain sectors. Generally, hedge funds focus on delivering strong short-term returns and as a result, the underlying investments may shift frequently.

One thing to note is that hedge funds often cater to higher net-worth investors. Specifically, that means accredited investors who meet certain standards set by the Securities and Exchange Commission. To be an accredited investor, you generally need to have $200,000 or more in annual income for the previous two years ($300,000 if you’re married) or a net worth of $1 million.

Because hedge funds expect to outperform the market, they can often be more expensive to invest in compared to traditional actively managed funds or passive funds. Hedge fund managers may collect a flat management fee as well as a performance-based fee. Given that hedge fund investors may have a net worth in the millions or even billions, hedge fund managers are often some of the most highly compensated fund managers in the market.

Private Equity, Explained

Private equity is another way of describing ownership in companies that are not publicly traded on a stock exchange. Private equity firms invest in these companies, usually through a private equity fund. Alternatively, private equity firms may purchase publicly traded companies and delist them from a stock exchange. The goal of private equity is to invest in companies that have growth potential with the intention of selling ownership stakes at a profit later on.

A private equity firm may hold ownership in multiple private companies at any given time, acquiring new companies and selling others to generate returns. Venture capital is an offshoot of private equity, though the focus is typically on startups rather than established companies.

When you invest in a private equity fund, you’re investing in a pooled investment managed by a private equity firm. The fund holds a controlling interest in one or more private companies and that interest allows it to have a say in how the company is managed. Again, the underlying goal is increasing the company’s value so that when it’s time to sell equities later, the fund turns a profit.

Like hedge funds, private equity funds are directly open only to a select group of investors. That includes accredited investors as well as institutional investors. The minimum investment for these funds can be quite high, often in the millions of dollars, which increases the exclusivity factor.

It’s possible, however, to have access to private equity funds indirectly if you have a pension plan at work or you own an insurance policy. Pension companies and life insurance companies may invest part of their portfolios in private equity investments. So if you have either one, some of your money may be attached to a private equity fund.

Hedge Fund vs. Private Equity: Which Is Better for Investors?

Whether hedge funds or private equity is a better investment ultimately depends on an individual investor’s goals and objectives. In terms of cost, both hedge funds and private equity tend to be more expensive than a typical mutual fund investment. Both can carry much higher management fees but this is typically justified by the higher returns these funds can generate.

Both hedge funds and private equity tend to be riskier than other investment vehicles. With hedge funds, interest rate risk, currency risk and equity risk can all influence returns. If a hedge fund reports a loss rather than a gain because of speculative trading activity, for example, it’s quite easy for investors to lose money.

With private equity funds, investors are taking a risk on whether a company included in the fund will reach its full growth potential. If the company doesn’t increase in value as expected then investors may not reap as large of a profit as initially anticipated. It’s possible that investors could even lose money on private equity funds if a company experiences a major drop in value.

Liquidity is also an issue with private equity funds. Unlike hedge funds, which are often focused on the short-term, private equity funds can involve a much longer time horizon. That increases liquidity risk since your money may be tied up in the fund for years before a particular holding is sold.

Hedge Funds, Private Equity and the Stock Market

While you may not own hedge funds or private equity directly, that doesn’t mean you can overlook them entirely. These funds and how they’re managed can play a part in directing market trends. For example, hedge funds can create a trading bubble around a particular asset or asset class which can affect stock market volatility.

A recent example of this is the bubble that was created around mortgage-backed securities. Hedge fund trading activity surrounding these securities helped trigger the events that eventually lead to the 2008 financial crisis.

Private equity can likewise be problematic for investors as a whole because they often involve high amounts of leverage. In other words, these funds may use borrowed money to invest. If a private equity fund defaults on its obligations, that could have negative consequences for the broader market.

How to Invest in Hedge Funds and Private Equity

If you don’t meet the income or net worth standards to invest in hedge funds or private equity directly, there is another way to add them to your portfolio. Hedge fund exchange-traded funds (ETFs) and private equity ETFs offer access to these investments to a broader group of investors.

An ETF holds a collection of securities. Hedge fund ETFs and private equity ETFs rely on investment strategies that mirror those of traditional hedge or private equity funds. The advantage to investors is that they often have much lower minimum investments, so they’re more accessible. And you may pay less in fees to own either one since they tend to have lower expense ratios.

When comparing hedge fund ETFs or private equity ETFs, pay attention to the fund’s strategy and its underlying investments. Also, consider the ETF’s performance, risk profile, and cost. If you’re ready to start investing in private equity ETFs or hedge ETFs, you can do so by opening an online brokerage account.

The Bottom Line

The differences between a hedge fund vs. private equity are noteworthy, largely due to how these funds execute their respective investment strategies. Even if you don’t invest in either one, it’s helpful to understand how they work and what they can mean for your portfolio as they affect the overall market.

Tips for Investing

Consider talking to a financial advisor about hedge fund ETFs or private equity ETFs and where they might fit into your investment portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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