Hedge Fund vs Mutual Fund

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Article Content

What is a Hedge Fund?
Types of Hedge Funds
How does Hedge Fund work?
Who Should Invest in a Hedge Fund?
What is a Mutual Fund?
How do Mutual Funds Work?
Who Should Invest in Mutual Funds?
Hedge Fund vs Mutual Fund

Mutual Funds are a common investment option that offers secure returns and helps you manage risks. Hedge funds are slowly gaining popularity in India but are not as widely accepted as mutual funds. Like mutual funds, Hedge Funds also pool investments from various investors and implement highly complex strategies to ‘hedge’ risks. Here is a comparison of Hedge Funds Vs Mutual Funds for your better understanding before investing in them.

What is a Hedge Fund?

Hedge mutual funds are set up as private investment limited partnerships. They are classified as a type of mutual fund and invest in securities.

Securities and Exchange Board of India (SEBI) defines them as follows “Hedge funds, including fund of funds, are unregistered private investment partnerships, funds or pools. They may invest and trade in many different markets, strategies, and instruments (including securities, non-securities, and derivatives). Hedge funds are not subject to the same regulatory requirements as mutual funds.” Hedge funds in India must not be necessarily registered with SEBI. They are also not bound to disclose their NAVs at the end of the day. Unlike other mutual funds, they are not required to follow the regulatory requirements of SEBI.

Types of Hedge Funds

You can classify them depending on the securities they invest in and the kind of strategies for managing them.

Following are the different types of hedge funds:

Domestic hedge funds: A Domestic hedge fund is open to investors only from the origin country. They must be subject to the country’s taxation.
Offshore hedge funds: An offshore hedge fund is established outside of the origin country. They may preferably be based in a low taxation country.
Fund of funds: Fund of funds are mutual funds that invest in other hedge mutual funds instead of individual underlying securities.

How does Hedge Fund work?

Hedge Funds use different types of trading techniques depending on the securities and assets they invest in. They may invest in equities, debt, and derivatives including futures and options. Their trading technique is similar to those of equities and debt securities. Therefore, it could be trading in the stock market or buying it directly from the company in a private placement.

Hedge funds pool money from big investors like high-net-worth individuals (HNIs), endowments, commercial firms, banks, and pension funds. These funds fall under the Alternative Investment Funds (AIF) -category III. The pooled money is used to invest in securities, they may be listed in national and international markets. These securities can invest in equities, bonds, currencies, real estate, convertible securities, and derivatives.

Who Should Invest in a Hedge Fund?

Hedge funds are privately managed mutual funds that are handled by experts. They are costlier than mutual funds making them affordable only for the financially well-off. In addition to owning surplus funds, an investor must also be an aggressive risk-seeker. Fund managers buy and sell assets at high speed as they try to keep up with the market movements.

Hedge Funds involve a higher risk owing to their structural complexity. Hence, they demand a higher expense ratio (fee to the fund manager) than regular mutual funds. It may range from 15% to 20% of your returns. It is not recommended for first-time depositors and is only fruitful for investors with considerable experience in the field. The success of a fund depends largely upon its fund manager. Therefore, invest in hedge funds only if you have full faith in your fund manager.

What is a Mutual Fund?

Mutual Fund is a trust for collecting money from investors. It invests them in different asset classes according to the investor’s investment objective. The investors share a common financial goal and mutual funds help to achieve them. Mutual funds can also be defined as a financial intermediary. They are set up with an objective to professionally manage the investors’ money.

Mutual fund investors can enjoy economies of scale by pooling their money. They can purchase stocks or bonds at much lower trading costs in comparison to direct investing in capital markets. Investors also get additional advantages such as diversification, stock, and bond selection by experts, lower costs, the convenience of investment, and flexibility.

The mutual fund allots units to each investor in accordance with the quantum of money invested. Each unit represents the proportionate ownership of an investor into the assets of a scheme. An investor’s liability in case of loss to the fund is limited to the extent of the amount invested.

How do Mutual Funds Work?

Mutual funds gain their strength from the pooling of resources. You have to invest relatively lower amounts of money in a mutual fund scheme. This enables small retail investors to enjoy professional money management and offers them access to different markets. It gives you exposure to the markets which otherwise you may not be able to access.

The investment amount is pooled and handed over to experts known as ‘Fund Managers’. They invest the pooled money on behalf of investors of the scheme. These managers make investment decisions pertaining to the selection of securities and investment proportions. However, the decisions made by the fund managers are governed by certain guidelines. They also depend on the investment objectives, the pattern of the scheme, and other regulatory restrictions. Investors also choose the right fund based on their investment objective and pattern; these should be in line with their investment purpose. For instance, risk-averse investors can opt for capital protection schemes, while aggressive investors can invest in mid or small-cap segments of the equity market.

The diversity in investment objectives and mandates is useful for classifying and sub-classifying mutual fund schemes. Broadly it is classified in the following asset class levels – Equity Funds, Bond Funds, Liquid Funds, Gilt Funds, Balanced Funds, and others. The subcategories of these are – mid-cap funds, small-cap funds, index funds, sector funds, etc.

Who Should Invest in Mutual Funds?

Investors with clear investment objectives should invest in mutual funds. You should have a moderate to high-risk appetite as all mutual fund investments are subject to market risks. Selecting the right mutual fund is also crucial as it should be in line with your requirements. You should also take into consideration the credibility of your fund manager before investing. This may also influence the expense ratio of your investment.

Mutual funds are ideal investment instruments for investors looking to diversify their portfolios while keeping risk under control. They are also recommended for investors who do not want direct exposure in equities markets.