In the world of investments, if you know about mutual funds, chances are you have also heard about hedge funds. Although mutual and hedge funds both pool funds from multiple investors, they are different investment vehicles in terms of strategies, risk profiles, and accessibility. Understanding the distinctions will help you make an informed decision. This article on mutual funds vs hedge funds will provide insights into their differences and considerations for potential investors.
What Are Mutual Funds?
In simple terms, mutual funds are investment products that pool funds from multiple investors and invest in diverse portfolios of investment securities such as bonds, stocks, money market instruments, and other assets. Investors typically buy units in the mutual fund. The fund’s returns are directly related to the performance of the underlying security.
Mutual fund investing is for general investors. Retail investors with limited investment money are usually more inclined towards mutual fund investing. Such funds offer moderate returns but higher security on the principal.
Mutual funds are actively or passively managed based on the nature of the fund.
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What Are Hedge Funds?
Hedge funds pool funds from accredited investors or institutional investors to invest in high-return-generating investments. Fund managers use diverse and aggressive investment strategies to earn higher returns. The number of investors in a hedge fund is restricted, but they are usually large investors with a higher risk appetite and the ability to absorb more risk.
Unlike mutual funds, hedge funds have more flexibility and can invest in a wide range of assets, including stocks, bonds, commodities, and currencies. They typically charge a management fee (based on AUM) and a performance fee (a percentage of profits). The minimum investment size is Rs. 1 crore per investor, and the fund needs to have a minimum corpus of Rs. 20 crore.
Hedge fund managers are responsible for the fund’s functioning and performance.
Here are some basic characteristics of a hedge fund:
- Hedge funds are unregistered in India.
- The investors are primarily private investors with large investment funds.
- Fund managers use strategies such as short selling and leveraging on their holdings for more profit.
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Mutual Funds vs Hedge Funds: Key Differences
Mutual funds and hedge funds are different financial products. Following are the key differences between mutual funds and hedge funds.
Fundamentals
They both pool funds, but the fundamental difference lies in their investment strategies and investor accessibility. Mutual funds are open to the public, offering diversified portfolios with long-term investment goals. Hedge funds, on the other hand, employ more complex investment strategies. These funds are restricted to private, high-net-worth investors.
There are also restrictions on the minimum investment limit. Most mutual funds will allow investors to start with a minimum investment of Rs. 1,000 (it is subject to variation between companies and funds). Hedge funds require a minimum investment of Rs. 1 crore.
Investors type
Hedge funds are for accredited investors who are experienced, have advanced knowledge of the market, and have a higher appetite for risk.
Compared to that, mutual funds offer risk-adjusted returns. The fund manager will spread the fund to earn maximum returns with minimum risk. The objective is to generate returns similar to a market benchmark.
Asset allocation
Mutual funds in India are regulated by SEBI in their investment strategies. Fund managers need to follow specific guidelines regarding investing and can only invest in a restricted bouquet of securities.
Mutual fund managers primarily invest in stocks, bonds, and cash equivalents, aiming for long-term growth and income.
Hedge fund managers are given more flexibility in their choice of securities. They can use riskier strategies, such as leveraging, in their holdings, which increases returns but also increases volatility.
Hedge fund managers can invest in a broader array of securities, including stocks, bonds, commodities, derivatives, and currencies, often employing complex trading strategies to maximise returns.
Liquidity
Mutual funds are more liquid. Most mutual funds let investors redeem their units at any time.
Hedge funds may have restrictions regarding liquidity. Some funds may not allow redemption in a volatile market to protect investors from probable selloffs.
Regulations
Hedge funds are private funds; not regulated by the Security and Exchange Board of India. They don’t publish periodic disclosures of Net Asset Value (NAV) like mutual funds.
Charges
Hedge funds’ charges are higher fees than that of mutual funds. The fee structure is known as ‘two and twenty,’ where the hedge fund company charges 2% of the fund as an asset management charge and 20% of the profit.
Hedge fund managers actively manage the fund, which increases the cost of investing.
Risk and return
Hedge funds target high returns, which increase the volatility of the fund. The return on hedge funds can go up to 15%.
Mutual funds generally offer lower risk and potential returns compared to hedge funds.
Taxation
Hedge funds fall under the category of Alternative Investment Funds (AIIF). Funds falling under category III of the AIF, an annual earning exceeding Rs. 5 crore are taxed at 42.74%. They don’t enjoy pass-through status for taxation like mutual funds, and the tax amount is deducted at the fund level.
Here is a table of differences between mutual funds vs hedge funds.
| Criteria | Mutual funds | Hedge funds |
| Regulatory requirements | Regulated by SEBI and mandated to produce a daily disclosure of the NAV report | Not regulated by SEBI |
| Investor category | Open to the public | Restricted to accredited investors |
| Underlying securities | Equities, bonds, money market instruments, cash | Equities, money market instruments, real estate, derivatives, and convertible securities |
| Risk | Moderate risk for long-term growth | Very high |
| Minimum investment | It varies but can be as low as Rs. 500 for some funds | The minimum ticket size is Rs. 1 crore |
| Minimum fund size | No minimum amount defined | Rs. 20 crore |
| Investment strategy | Short selling is not permitted | Short selling and leverage are often used |
| Cost | Expense ratio as per SEBI regulations | Specific to the fund |
| Liquidity | High | Decided by the fund manager |
| Transparency | Very transparent | Limited transparency. The details are disclosed only to investors |
| Tax | Pass-through tax vehicles. The investor pays tax on capital gain as per the Income Tax slabs | Tax is paid by the fund |
| Investment Strategy | Investing in a diversified portfolio according to the investment strategy of the fund | Short selling, arbitraging, investing towards future events, investing in securities with high discounts |
Conclusion
Mutual funds and hedge funds are both investment vehicles. By understanding mutual funds vs hedge funds, you can make an informed investment decision. For more investor education articles, follow Angel One’s Knowledge Centre.
FAQs
Mutual funds vs hedge funds: which is better?
The key difference between the two is that hedge funds employ aggressive investment strategies for higher returns. But hedge funds are also riskier than mutual funds.
Mutual funds are low-risk, moderate-return investments for long-term gains.
Which is riskier: mutual funds or hedge funds?
Hedge funds are higher-risk investments than mutual funds. Hedge fund managers employ aggressive and complex investment strategies, such as leveraging their holdings for more profit. It increases the return but also increases the volatility of the fund.
How do hedge funds generate returns?
Hedge fund managers invest in a vast array of securities, employing complex and aggressive investment techniques.
How are hedge funds taxed in India?
Hedge funds fall under the Alternative Investment Funds III category and are taxed at the fund level. The current tax rate is 42.74% for annual earnings exceeding Rs. 5 crore.
