Difference Between Hedge Fund vs. Mutual Fund

What is a Hedge Fund?

There’s no exact definition of the term “Hedge Fund” and it is perhaps undefined in any securities laws in India. Neither is there an industry wide definition nor a universal meaning for this term. Hedge funds, such as fund of funds, are unregistered private investment partnerships/or funds/or pools that may invest and trade in various markets, strategies and instruments such as the securities, non-securities and derivatives. They are not subject to the same regulatory requirements as mutual funds like the mutual fund requirements to provide certain periodic and standardized pricing and valuation information to the investors.

The term hedge fund can also be described by considering the characteristics most commonly associated with the hedge funds. Hedge funds typically take the form of private investment partnerships or offshore investment corporations; they use a wide range of trading strategies that involve taking positions in various markets; they use a variety of trading techniques and instruments, such as leverage, short sales, and derivatives; they pay their managers performance fees; and their investor base is made up of wealthy individuals and institutions with relatively high minimum investment limits (most funds have minimum investment limits of US $100,000 or more). 

In the 1950s, the term hedge fund came into use for the first time to describe any investment fund that used incentive fees, short selling & leverage. Over time, the hedge funds started diversifying their investment portfolio to add other financial instruments and get involved in a wider variety of investment strategies. 

Hedge funds nowadays trade currencies, exchange-traded futures, over-the-counter derivatives, futures contracts, commodity options, fixed income securities, convertible securities, and other non-securities investments in addition to equities. Furthermore, many hedge funds currently operate in considerably traditional, long-only equity strategies, and some may or may not use the hedging and arbitrage tactics that hedge funds historically employed. 

What is a Mutual Fund?

A Mutual Fund is a trust which collects money from investors who have a common financial goal, and invests the proceeds in different asset classes as defined by the investment objective. To put it simply, a mutual fund is a financial intermediary set up with an objective to professionally manage the money pooled from the investors at large.

Investors can enjoy economies of scale and purchase stocks or bonds at much lower prices compared to direct investing in capital markets by pooling money together in a mutual fund. Diversification, stock and bond selection by experts, low costs, flexibility and convenience are other benefits of a mutual fund.

In a mutual fund scheme, an investor receives units in accordance with the quantum of money he’s invested. These units show how much of an investor's equity is invested in the scheme's assets, and his liability in case of loss to the fund is limited to the extent of the amount invested by him. The main benefit of mutual funds is the pooling of resources. The relatively lower quantities necessary for investing into a mutual fund scheme enables small retail investors to experience the benefits of professional money management and gives access to diverse markets, which may not otherwise be accessible to them. 'Fund Managers' are the financial specialists who manage the scheme's investor pool on the investors’ behalf. 

These fund managers are the ones who make investment decisions related to the selection of securities and the investment proportion to be made into them. However, these decisions are governed by certain guidelines which are decided by the objectives of the investment, the scheme's investment pattern and are subject to regulatory conditions. 

The investor is also guided in selecting the appropriate fund for his investment purpose by this investment objective and investment pattern.

These days, mutual funds in India offer a wide range of schemes that cater to different investor categories and suit different financial objectives. For example, some schemes may protect capital for risk-averse investors, while others may allow more aggressive investors to increase their capital by investing in the mid- or small-cap equity market.

The schemes have been categorized and subcategorized based on the range of investment mandates and objectives. At the asset class levels, a broad classification can be carried out. Thus, we have funds for stocks, bonds, liquid investments, balanced investments, gold investments, etc. These can be divided into other subcategories such as index funds, sector funds, small cap funds, and mid cap funds. 

Key Differences between Hedge Fund and Mutual Fund

Now that we have learnt about what hedge funds and mutual funds are, let’s know about their key differences using the table below:

How can you pick between Mutual vs Hedge Fund?

When it comes to choosing how to distribute the investment funds, the investors have many options at their disposal including bonds, stocks, mutual funds, hedge funds, to alternative investments and more. Ultimately, the investor’s decision is affected by their risk tolerance and financial goals.

For Investments that are Short Term

• Liquidation: If you require quick access to your funds, a more suitable option would be mutual funds due to their daily liquidity which allows for easier buying and selling of shares.
• Risk Tolerance: If you have short term goals as an investor, where preservation of capital is really important for you, mutual funds are the preferred option as they are usually considered as less risky compared to hedge funds which generally involve more complex strategies and higher volatility.
• Fee: The mutual funds have a lower minimum requirement and fees so they are a better option for the short-term investors who do not want to commit significant capital of theirs.

For Investments that are Long Term

• Potential for Return: Due to their aggressive investment tactics, hedge funds may provide the possibility of longer-term, greater returns. If you are an individual who has a longer investment horizon and a high tolerance for risk, a hedge fund maybe a better option for you.
• Diversification: Since mutual funds offer exposure to a range of asset classes, they are a good choice for long-term investors who are looking to diversify their portfolio. In the long term, this can help in risk management.
• Access to Wealth Managers: Hedge funds frequently serve HNWIs who may have access to wealth managers. A hedge fund may be a possibility for you if you're looking for individualized guidance and management for a long-term investment plan.

The decision between hedge funds and mutual funds ultimately depends on your investment horizon, risk tolerance, and financial objectives. Hence, it is really important to do your own research and/or consult an investment financial advisor before you start your investment journey.

Who should make an investment in Hedge Fund vs Mutual Fund?

Opting for a Hedge Fund might be suitable if:

• You are an individual having a high net worth.
• You are seeking potentially higher returns, even if there’s more risk.
• You are an individual who is comfortable with limited transparency.

Going for a Mutual Fund might be suitable if:

• You want diversification without the requirement of selecting individual stocks.
• You value daily liquidity and prefer lower fees.
• You are seeking a regulated and easily accessible investment choice.
• You are satisfied with the returns that closely mirror market performance.

Conclusion

The investors can make the best investment choices when they know the differences between hedge funds and mutual funds. Although both forms include combining individuals' funds to accomplish group investment goals, their approaches, risk tolerances, and legal environments differ. The hedge funds chase the big fish i.e., investments that come with high risk and high reward. Mutual funds can catch smaller but more reliable returns. Before making an investment, investors should conduct independent research or speak with a financial professional, such as a mutual fund distributor or SEBI-registered investment advisor.

Author: Dushyant Sharma

Hey there, I'm Dushyant Sharma. With the extensive knowledge I've gained in past 8 years, I have been creating content on various subjects such as banking, insurance, telecom, and all the important registration and licensing processes for various companies. I'm here to help everyone with my expertise in these areas through my articles.