Capital gains tax is the difference between becoming a Millionaire or Billionaire

​By Leslie M

Courtesy of NWI Chronicle

The difference between an index fund, a mutual fund, and a hedge fund is the level of risk incurred by the investor. To invest in hedge funds as an individual, you must be an institutional investor, like a pension fund, or an accredited investor. Accredited investors have a net worth of at least $1 million, not including the value of their primary residence, or annual individual incomes over $200,000 ($300,000 if you're married). However, some research indicates you should aim to have at least $5 million in assets under management to be successful. (AUM, which is the total market value of the investments managed by a person or entity on behalf of investors) Noted investors look to bring $20 million, although having $100 million will get you noticed by institutional investors. A hedge fund's purpose is to pool funds, maximize investor returns, and eliminate risk with strategies of hedging. 

Like mutual funds, hedge funds are actively managed by professional managers who buy and sell investments with the stated aim of exceeding the returns of some sector or index of the markets. Hedge funds aim for the greatest possible returns and take the greatest risks while trying to achieve them.

Hedge funds are generally structured as pass-through entities, allowing them to pass their entire tax obligation along to their investors or limited partners. Investors report their share of the fund's income or losses on their individual tax returns. 

Mutual fund investors see capital gains paid out right away, by law, while most index fund holders only realize the tax they will need to pay at the time of the sale of the investment product. 

 Index funds typically have lower expense ratios compared to actively managed mutual funds because they aim to measure how good or how poorly a specific index is performing, rather than actively selecting and managing individual investments. 

Mutual funds are regulated public investments available for daily trading. Hedge funds are private investments that are only available to accredited investors. Hedge funds are known for using higher-risk investing strategies with the goal of achieving higher returns for their investors.

Another key difference between index funds and mutual funds is the approach to management. Mutual funds can be actively managed or passively managed, while index funds are typically passively managed. Active management involves a team of professionals who actively research, select, and trade securities based on their analysis and market outlook. Passive management aims to replicate the performance of a specific index by holding the same securities in the same proportions as the index. 

In terms of performance and risk, index funds and mutual funds can vary. Index funds aim to mirror the performance of a specific index, their returns will generally align with the overall market performance represented by that index.

Actively managed hedge funds and mutual funds, on the other hand, rely on the expertise of the fund manager to outperform the market or achieve specific investment objectives. This active management can potentially lead to higher returns, but it also comes with higher fees and increased risk.  This structure and these objectives may remind you of a mutual fund but that's where the similarities end.

Since hedge funds can only accept money from accredited investors, considered suitable to handle the potential risks that hedge funds are permitted to take, hedge funds are loosely regulated so they can operate. A hedge fund can invest in land, real estate, stocks, derivatives, and currencies while mutual funds use stocks or bonds as their instruments for long-term investment strategies. Unlike mutual funds where an investor can elect to sell shares at any time, hedge funds typically limit opportunities to redeem shares and often impose a locked period of one year before shares can be cashed in. Hedge funds pool money from investors and invest in securities or other types of investments with the goal of getting positive returns. Investors should consider their investment objectives, risk tolerance, and time horizon when choosing between hedge, index and mutual funds.

Both index funds and mutual funds offer investors various investment options and the opportunity for diversification. Mutual funds can invest in a wide range of assets, including stocks, bonds, and other securities, depending on their investment objectives.

Index funds, on the other hand, focus on replicating the investments of a specific index, such as the S&P 500 or the Dow Jones Industrial Average. This can provide investors with exposure to a diversified portfolio without the need to individually select and manage multiple investments.

All index funds are a type of mutual fund, not all mutual funds are index funds. Index funds offer lower expenses, passive management, and diversification by replicating a specific index. Mutual funds, both active and passive, can provide opportunities for higher returns but may come with higher fees and increased risk. 

This is where Mutual funds and Hedge funds differ.  Investors must determine if the fund is using leverage or speculative investment techniques which will typically invest both the investors’ capital and the borrowed money to make investments.

Investors should evaluate potential conflicts of interest disclosed by hedge fund managers and research the background and reputation of the hedge fund managers.

Understand how a fund’s assets are valued as hedge funds may invest in highly illiquid securities and valuations of fund assets will affect the fees that the manager charges

 An investment time horizon is the period of time one expects to hold an investment until they need the money back. Time horizons are largely dictated by investment goals and strategies. Unlike stocks and ETFs, mutual funds trade only once per day, after the markets close at 4 p.m. ET. If you enter a trade to buy or sell shares of a mutual fund, your trade will be executed at the next available net asset value, which is calculated after the market closes and typically posted by 6 p.m. ET. The common rule of thumb is that the longer the time horizon, the more money you should allocate to stocks, equity funds, and other risky investments.

A short time horizon is anything up to three years. A medium time horizon falls between three and 10 years. A long time horizon is anything longer than 10 years. A Hedge fund's average lifespan is about five years, and many of them don't even make that. A 2014 New Yorker article reported that out of an estimated 7,200 hedge funds in existence at the end of 2010, 775 failed or closed in 2011, as did 873 in 2012, and 904 in 2013, a 2018 study found through Google search, said.

The more time that passes before you need to convert investment assets to cash, the more volatile risk you can tolerate. That’s because you’ll have a greater ability to recover from any market downturns that may happen along the way.

Once you’ve nailed down your financial goals and time horizon, you can decide on the types of investment assets and rates of return required to hit your targets.

Growth stocks appreciate rapidly but also deliver lots of volatility along the way.

Experts recommend keeping your money in cash and bonds to protect the principal no matter what’s going on in the markets, sacrificing growth for the sake of stability.

Different types of assets behave differently in various market and economic environments. Which one or more types of assets you use depends on your goals and on your stomach for volatility. But more than anything, it depends on your time horizon.