Hedge funds vs. mutual funds

Some market watchers say mutual funds have had their day, but take a hard look at the alternatives before you count them out.

By Pat Regnier, Money Magazine senior editor

(MONEY Magazine) -- Chastened by the 2000-02 crash, the mutual fund industry has morphed into a 401(k) bureaucracy, cranking out bland diversified funds and packaging them into "life cycle" portfolios that you don't have to think much about.

All the glitz these days is in the secret-handshake world of hedge funds. Meanwhile, for those who just want a cheap and easy way to get into the market, exchange-traded funds (ETFs) are giving mutual funds a serious run for their money.

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So are mutual funds only for chumps now? Plenty of smart folks seem to think so. David Swensen, Yale University's chief investment officer, has famously labeled the fund industry as a whole a "colossal failure."

But even if that's true, it doesn't mean you can't do well investing in mutual funds - as long as you pick ones that don't waste your money. And once you've taken a closer look at hedge funds and ETFs, you'll see that they are a long way from replacing mutual funds as the best way for most of us to invest.

The hedgies, especially.

Hedges, hogging fees

Hedge funds are simply private investment pools for institutions or wealthy individuals, with few of the regulations that apply to mutual funds. They wowed a lot of people in the wake of the crash: As blue-chip stocks lost a third of their value from 2000 through 2002, the average hedge fund made a decent profit.

How? Hedge funds vary wildly, but the main thing to know is that they can invest in nearly anything: stocks, bonds, private companies, real estate, commodities. So a rough patch in a key market doesn't close off all opportunity for profit. Plus, hedge funds can sell short, which means betting an asset will fall in price. That certainly came in handy during the crash.

On the other hand, hedge funds often cool when the stock market booms - as they have recently. That's why some of the smartest hedge fund clients don't buy to get huge gains. They buy to lower risk. Because hedge funds' returns need not be closely linked to those of, say, the S&P 500, they can help you diversify.

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The downside: To start with the obvious, most ordinary investors can't get in. By law, you need to be wealthy to qualify. And since classic hedge funds are allowed to take on only a limited number of clients, they typically have minimum investments of $1 million or more. That said, some variations on the classic model can be relatively accessible:

Funds of funds - that is, funds that invest in hedge funds - can have antes of $100,000 or less, and financial advisers are gaga over them. "It's another arrow in the marketing quiver," says Coral Gables, Fla. planner Harold Evensky, who doesn't use hedge funds.

Don't be too eager to join - and if you can't afford the price tag, don't waste your envy. For individuals, hedges are full of thorns. The first problem is cost: The funds often charge "2 and 20," which is a 2 percent annual fee plus 20 percent of profits above a benchmark. A fund of funds might add another 1 percent plus 10 percent on top of that, which may not leave much for you.

"Hedge funds are the most effective vehicles known to man for transferring assets to a fund manager," quips William Bernstein of Efficient Frontier Advisors.

But isn't it worth the higher price if hedge funds deliver? Only if you manage to find the right ones. And good luck with that.

"Just as with mutual funds, you have a few great talents at the top and a broad group of mediocre ones in the middle," says Ryan Tagal, head of hedge fund research at Morningstar. "Except with hedge funds you are paying 2 and 20."

Or maybe 3 and 30. And since the best hedge funds can and often do turn away business, what are the odds that you'll find a winner among the second-and third-tier funds that are left? Slim.

If you really want hedge-like diversification, there are mutual funds that offer some hedge strategies without the steep price. Morningstar fund analyst Todd Trubey points to two: the Merger Fund and Hussman Strategic Growth.

Both move out of sync with the S&P 500 and did well during the bear market. As you'd expect, they've done less well in the rebound. Over the past five years, Merger has gained an annualized 6.3 percent, Hussman 7.5 percent. But even they are optional. "If I want to lower risk in my portfolio, I buy Treasury bills," says Bernstein.

Keeping it simple with ETFs

ETFs are index funds that trade exactly like stocks. As with index mutual funds, there's no manager deciding to buy and sell investments every day. Instead, you get (nearly) pure exposure to whatever asset or group of stocks the ETF tracks.

The advantage of this is that without an expensive manager and researchers to pay, an ETF can keep the annual expenses vanishingly small: The Vanguard Total Stock Market ETF, which exposes you to thousands of U.S. companies, charges just 0.07 percent a year. ETFs with more focused investments may cost as much as 0.85 percent, but that's still less than a typical actively managed mutual fund.

You can buy ETFs to invest in any of the key market benchmarks, such as the S&P 500 or the MSCI EAFE index of foreign markets. ETFs (and similar products called exchange-traded notes) also allow you to diversify into assets that used to be hard to buy, such as commodities. That's another reason you can skip hedge funds.

The downside: Mutual funds can index cheaply too. And often - especially if you're just beginning to build wealth - they're the better choice. You have to use a brokerage to buy ETF shares. That's no problem if you're investing a big sum: A $10 commission adds 0.1 percent to the cost of a $10,000 purchase and even less to the sale, if your investment grew.

When you invest in $100 installments, though, a $10 commission is 10 percent each time. This may not always be a barrier: Brokerage costs keep falling, and 401(k) plans are finding ways to offer low-cost ETF trades. But in general, ETFs make sense only if you trade rarely and in large amounts.

The other thing to know about ETFs is that apart from those tracking broad indexes, most are no good for you. Jim Wiandt, editor of the Journal of Indexes, observes that some investment firms are opening ETFs as fast as they can.

More than 100 have launched in 2007 alone, says Morningstar. You can now buy the Dutch market or track nanotechnology stocks and cancer therapies. Trading in and out of narrow bets like these will profit your broker, but you probably won't be able to outwit the market with them. Steer clear.

The verdict on mutual funds

The success of ETFs and hedges says a lot about how mutual funds fall short. Hedgies gain their edge by being different, whereas most mutual funds swim in the same pool of widely followed U.S. stocks. And since the typical mutual fund charges 1.4 percent a year, odds are that in the long run it won't beat an index ETF tracking the same pool for 0.07 percent.

Even so, you can mimic an index through a mutual fund as easily as through an ETF, and you can diversify away from the index with some mutual funds much more easily than with a hedgie. It's true: You don't need most mutual funds. But choose wisely and a few of them can get you all you need. Top of page

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