For many people, hedge funds and investment banks are both terms that are synonymous with rich people, but the differences between the two are significant.A hedge fund manages a highly diverse investment portfolio that aims to generate outsized returns. They invest accordingly, then sell shares in their portfolios to third parties. They make money off their portfolios’ returns.An investment bank manages finances for their clients, helping companies raise capital and managing complex transactions for both buyers and sellers. They make money off fees they charge clients.
For help with investment banks, hedge funds or any other money questions, consider working with a financial advisor.
What Is a Hedge Fund?
A hedge fund is a portfolio-based investment product.
The fund itself invests in a number of different assets, and the portfolio generates returns based on the collected returns of those underlying holdings. Outside investors can then buy shares in this portfolio, the same way that you can buy shares of a mutual fund or an ETF, and they make money based on their proportional ownership of the overall fund.
A hedge fund makes its money off a combination of fees and the capital appreciation of portfolios. One way is through fees. Hedge funds will charge its clients to invest in the portfolio, and these fees represent the work that goes into actively managing the fund. The firm will generally take both a flat fee (for example, you might pay an annual fee worth 2% of your total holdings) as well as a proportion of returns (for example you might also owe 10% of your portfolio’s profits each year).
Hedge funds can invest in an extremely wide variety of assets. They are privately traded, meaning that they are subject to relatively little SEC oversight, and they can only take money from institutions and accredited investors. This allows them to invest in virtually any legal financial product or asset. While a hedge fund’s portfolio will often include mainstream assets like stocks and bonds, they will also frequently invest in more high-risk assets like startup companies, speculative real estate, derivative securities, emerging technology, art, short sales, commodities and anything else the fund’s managers believe will generate strong returns.
Typically hedge funds will invest around a theme. For example, you might invest in a technology-oriented hedge fund that makes high-tech investments, or a real estate hedge fund that seeks out good property deals.
The goal of a hedge fund is build an investment portfolio that outperforms the market. They seek large returns, but in doing so accept larger risks.
What Is an Investment Bank?
An investment bank, which is different from a commercial bank, is a financial institution that helps companies and clients manage large-scale financial transactions. Two well-known investment banks are Morgan Stanley and Goldman Sachs. Their work generally takes two forms:
Buyer’s side – Here the bank helps institutions and individuals that are looking to make large investments or otherwise manage large amounts of capital;
Seller’s side – Here the bank helps institutions and individuals looking for large amounts of capital, such as by selling investment products or debt notes.
Investment banks generally do business with large organizations, such as companies and brokerages. They do, on occasion, work with particularly high net worth individuals, but only when large amounts of capital are involved.
An investment bank differs from what is known as a “depository bank” in that it doesn’t hold money on behalf of individuals, such as in a checking or savings account. Instead it helps clients exchange financial products, and the bank makes its money off the fees and commissions it charges for this service. For most of the 20th century investment banks were entirely barred from acting as depository banks, at least for non-accredited individuals. This law was partially repealed in November 1999.
Examples of the kind of work an investment bank will do include:
When a company wants to launch an initial public offering (IPO), that is, go public, it will hire an investment bank to conduct the review and oversight process and to find initial buyers for the company’s stock. An investment bank will conduct a similar process when one of its clients wants to issue additional shares, conducting the necessary financial audits and selling the shares to new investors.
Investment banks will help institutions raise money through debt by issuing bonds. As with helping companies sell their stock, this involves conducting the necessary financial oversight and finding investors to buy the bonds.
An investment bank will help firms to merge, acquire each other or otherwise conduct large scale stock transactions.
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Portfolio Management and Stock Sales
Investment banks will often manage the portfolios of large private clients. For example, a company might deposit its employees’ retirement funds with an investment bank to manage the 401(k) portfolios. Another firm might hire an investment bank to help it buy back shares of its own stock, or to help sell shares of its stock on the secondary market.
Creating and Selling Secondary Products
Many investment banks will create what are known as secondary financial products. These are generally derivatives, assets that take their value from some other security or financial product. (For example, an options contract is a derivative because it gives you the right to buy or sell some underlying asset and takes its value from that right.) Investment banks will create these products and sell them, almost always to other institutional investors.
To be clear, this is a representative sample of the kind of work that investment banks do. Overall, their function is to help institutions raise and invest large amounts of capital. This is in many ways similar to how depository banks help individuals hold, raise and manage money.
The business model of an investment bank differs from a hedge fund in several ways but perhaps the most important is this: The business model of a hedge fund is to make investments and profit off their returns. The business model of an investment bank is to provide financial services to clients and profit from the fees it charges. A hedge fund offers the product that high-net-worth investors purchase. An investment bank offers the services for how they can invest.
The Bottom Line
A hedge fund offers people the chance to invest in a portfolio, with returns based on how well the portfolio’s underlying investments do. The fund itself makes most of its money from the fees and commissions that it charges based on those returns. An investment bank helps clients make large-scale financial transactions and makes its money off the fees it charges for this service.
If you want to understand the nature of investment banking, almost nothing is more important than learning about the history of the 1934 Securities Exchange Act and the 2010 Dodd Frank Act.
You may not be an institutional investor, but that doesn’t mean your money doesn’t matter – and a financial advisor can help you get the most out of it. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three 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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As a financial expert with extensive knowledge in hedge funds, investment banking, and related financial concepts, I can provide a comprehensive understanding of the terms discussed in the article.
Hedge Fund: A hedge fund is a portfolio-based investment product that manages a diverse range of assets with the goal of generating outsized returns. The fund makes money through a combination of fees and capital appreciation. Here are key concepts related to hedge funds mentioned in the article:
Investment Portfolio: A collection of various assets (stocks, bonds, real estate, derivatives, etc.) that a hedge fund invests in to generate returns.
Share Ownership: Investors can buy shares in the hedge fund, similar to mutual funds or ETFs, and earn money based on their proportional ownership of the overall fund.
Fees: Hedge funds charge fees for managing the portfolio. This includes a flat fee (e.g., annual fee based on a percentage of total holdings) and a performance fee (a percentage of the portfolio's profits).
Wide Variety of Assets: Hedge funds can invest in a broad range of assets, including high-risk options like startup companies, speculative real estate, and emerging technologies.
Private Trading: Hedge funds are privately traded, subject to relatively little SEC oversight, and can only accept money from institutions and accredited investors.
Thematic Investing: Hedge funds often invest around a theme, focusing on specific sectors like technology, real estate, or other areas believed to generate strong returns.
Risk-Reward Tradeoff: The goal of a hedge fund is to outperform the market, seeking large returns while acknowledging higher risks.
Investment Bank: An investment bank, distinct from commercial banks, facilitates large-scale financial transactions for companies and clients. The bank makes money through fees and commissions for its services. Here are key concepts related to investment banks mentioned in the article:
Buyer's Side and Seller's Side: Investment banks assist institutions and individuals in making large investments (Buyer's side) or acquiring large amounts of capital (Seller's side).
Financial Transactions: Investment banks engage in various financial transactions, including issuing stock for IPOs, bond issuance, mergers and acquisitions, and large-scale stock transactions.
Clientele: Investment banks primarily do business with large organizations, companies, and brokerages. They may also work with high net worth individuals in certain situations.
Fee Structure: Investment banks earn money through fees and commissions for facilitating financial transactions and providing advisory services.
Portfolio Management: Some investment banks manage portfolios for large private clients, such as handling 401(k) portfolios or assisting in stock buybacks.
Derivative Products: Investment banks create and sell secondary financial products, often derivatives, to institutional investors.
Regulatory Changes: The article mentions historical legislative acts, such as the 1934 Securities Exchange Act and the 2010 Dodd Frank Act, as important for understanding investment banking.
Business Model: Hedge funds make investments and profit from portfolio returns, while investment banks provide financial services and profit from fees charged for facilitating transactions.
Client Offerings: Hedge funds offer investment products to high-net-worth investors, while investment banks offer services for managing and facilitating large-scale financial transactions.
In conclusion, the article highlights the distinctions between hedge funds and investment banks, emphasizing their respective business models, client interactions, and revenue generation mechanisms.