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Mutual Funds Vs. Hedge Funds

Often times, people confuse hedge funds to function just like mutual funds. Although the two are pooled vehicles, they have distinct traits, processes, regulations and variations. In this page, we will dive into the two fund types and understand the differences between them.

What are Mutual Funds?

A mutual fund is a professionally managed investment fund where money of investors is pooled and invested in various securities. Such funds are operated by professional fund managers, who allot the fund's monies into various schemes with the aim of producing capital gains and/or income for the investors. The portfolio is structured to match the investment objectives, as mentioned in its prospectus. Mutual fund investors are given ownership in the assets of the fund, where the portion of ownership comes down to the funds contributed by each investor. Returns depend on the performance of the scheme - if the value goes up, the returns increase and if the value goes down, the return go down. Unitholders receive net income and capital appreciation in the ratio of their capital investment. Mutual funds can be classified into four main categories:

Equity Mutual Funds

Investments are made in stocks. Such schemes can fetch higher returns, but can be risky in the short-term since the returns depend on the performance of the stock market. Ideally, investors who are interested in these schemes should let their money stay parked for at least 5-10 years in these funds.

Debt Mutual Funds

These schemes are safer when compared with equity schemes and fetch modest returns. Debt mutual funds are an ideal option for investors seeking to meet their short-term goals that are below 5 years.

Hybrid Mutual Funds

Here, an investor’s money is invested in a combination of equity and debt. The individual must select a scheme keeping in mind his or her risk appetite.

Solution-oriented Mutual Funds

These schemes are designed for certain solutions or goals such as retirement and child’s education. They have a mandatory lock-in period of 5 years.

What are Hedge Funds?

A hedge fund is a form of an investment partnership. There is a professional fund manager - who is often known as the general partner, and investors - who can sometimes be referred to as the limited partners. The investors, which comprise of accredited investors such as banks, High Net-Worth individuals (HNIs) & families, insurance firms, and pension funds, will pool their money into the fund.

The purpose of hedge funds is to maximize investors’ returns and eliminate risk. They can operate as private investment partnerships or offshore investment corporations. There is no need for hedge funds to be registered with the securities market regulator, SEBI, and they are not subject to the reporting requirements, like disclosing NAVs periodically.

There are a number of strategies a hedge fund can adopt to maximize returns. Global macros is one such strategy where the fund takes long and short positions to profit from large economic and political changes in several countries. Then, there is the market-neutral strategy, where the fund manager will aim to minimize market risks by parking money in long or short equity funds, fixed income products, convertible bonds and arbitrage funds. A third kind involves event-driven funds, where investors’ money is parked in stocks to take advantage of price movements as a result of corporate events. Merger arbitrage funds as well as distressed asset funds come under this.

Difference between Hedge Funds and Mutual Funds

The following are some of the key difference between hedge funds and mutual funds:

Purpose

A hedge fund is an investment partnership among entities who pool large funds for high risk-high return investments. A mutual fund is an investment vehicle where money of retail investors is pooled and invested in various securities to match the investment objectives.

Flexibility

Under hedge funds, the fund manager can make major changes to strategies as he or she feels suitable. Such funds are generally more aggressive in nature. Fund managers of mutual funds are required to adhere to the strategy agreed upon at initiation.

Fees

Hedge funds normally levy a fee based on the fund's performance. The better the fund performs, the more will be the fees incurred by investors. Mutual funds, on the other hand, are highly regulated in terms of the fees that can be charged.

Ownership

The owners of a hedge fund are limited in number, whereas the number is much larger in case of mutual funds. The owners of a mutual fund can easily go up to thousands.

Regulation

Hedge funds are lightly regulated when compared with mutual funds. As listed above, there is no need for hedge funds to be registered with SEBI and they aren’t subject to certain reporting requirements. Mutual funds are strictly regulated by the securities regulator.

Secondary Market

There is no active secondary market in case of hedge funds. Given that such funds are exclusive, the units have to be sold back to the fund. Mutual funds may have a secondary market, which allows customers to sell their units to others and liquidate their money without requiring the fund to actually pay back.

Who should Invest in Mutual Funds?

Mutual fund schemes are designed to meet the investment objectives of nearly all kinds of investors. Thus, it is ideal option for everyone. Younger investors who are willing to take risks for substantial capital growth might find growth schemes a suitable option. Retired individuals looking for regular income can put their money into income schemes. Middle-aged investors can allot their funds between income and growth funds to attain both income and capital growth. To sum it up, those falling into any of the categories below can invest in mutual funds:

  • Retired individuals looking for regular income.
  • Individuals seeking to invest a lump sum amount for a long term to reap benefits later.
  • Salaried individuals looking to save some amount on a regular basis.
  • Individuals seeking to make a short-term investment to buy a car, buy a house, go for a vacation, etc.
  • Individuals aiming to save tax and increase investment returns.

Who should Invest in Hedge Funds?

Considering that hedge funds are privately managed by experts, they can be a bit costly. They are generally a feasible option for those with a solid financial standing. Not only does the investor need to be someone with surplus funds, he or she must also be an aggressive risk-seeker. The reason behind this is that the manager will buy and sell assets rather quickly so as to keep up with the market movements. The expense ratio for hedge funds are much more than mutual funds. It can be anywhere from 15% to 20% of the investor's returns. It is recommended that first-time depositors avoid this until the time they gain sufficient experience in the field.

FAQs on Mutual Funds Vs. Hedge Funds

What is the meaning of Net Asset Value in a mutual fund?

Net Asset Value (NAV) is the per unit market value of a fund. It is the price at which units are purchased or sold. All transactions are conducted at prices linked to the scheme’s NAV. The formula for calculating NAV is as follows: NAV = (Assets - Debts) / Number of outstanding units Here, assets will be the sum of the current market value of all the securities held, receivables and accrued income. Debts are the liabilities and costs borne to establish and manage the portfolio and service the investors. The net assets (assets minus debts) are divided by the total number of the scheme’s units on a particular day to arrive at the NAV.

Is there a minimum lock-in period for units?

In case of open-ended funds, there is no lock-in period. For tax saving funds, a lock-in period of 3 years will apply.

What factors have an influence on the performance of mutual funds?

Mutual fund performance will depend on the performance of the stock market and that of the economy. Those schemes where investments are primarily made in equity funds are largely influenced by the stock market. Bond funds, on the other hand, are influenced by credit quality and interest rates. When interest rates rise up, the bond prices will go down, and vice versa. Similarly, bond funds that have a higher credit rating are less impacted by changes in the economy.

What is a hedge fund portfolio made up of?

A hedge fund portfolio constitutes of asset classes such as derivatives, equities, leverage, bonds, currencies and convertible securities.

What are the costs associated with a hedge fund?

The fee structure comprises of management fee and expense ratio. In India, the management fee is generally less than 2%, with the profit share varying from 10% to 15%.

What is the meaning of expense ratio?

Expense ratio denotes a scheme’s annual fund operating expenses and is expressed as a percentage of daily net assets of the fund. Operating expenses include management, administration and advertising related expenses, among others.

What are the necessary documents to invest in mutual funds?

An individual will have to provide proof of identity, proof of address and passport size photograph to invest in a mutual fund.