Mutual Fund vs Hedge Fund

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21 Aug, 2024

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Difference Between Mutual Fund and Hedge Fund

The mutual funds and the hedge funds are investment funds where mutual funds are the funds available for investment to the public and are allowed for trading daily. In contrast, in the case of hedge funds, investments by only accredited investors are allowed.

Each individual or organization desires their money to grow rapidly, which they must invest. Various investments exist; some offer larger returns but may have to bear larger risks and vice-versa. In this regard, we will go through the investment options of mutual and hedge funds with the key differences between them.

Both funds are investment vehicles that will pool money from various investors to multiply them quickly and proportionate the risk level depending on the investors' appetite. A professional fund manager manages both these funds.

Let us understand each option in detail with the differences –

Difference Between Mutual Fund and Hedge Fund

What are Mutual Funds?

A mutual fund is an investment vehicle that pools money from multiple investors to purchase securities. These funds are generally risk-averse and focus on the regular increase in the Investment made in the stock market. The exchanges regulate them, and hence they must issue a prospectus that will clearly state the objectives of the fund and the strategies to be implemented. Accordingly, they have to abide by the same, infusing confidence in the investors.

Retail investors who have limited savings for investment purposes, in turn, become inclined toward this area of Investment. Such funds offer limited returns but, in turn, more security in the principal Investment that has been made. The funds are managed by a professional fund manager who has to manage the funds within the limits of the prospectus and maximize the returns within the ambit of the law. The fund manager doesn't need to include their Investment. Some of the other important advantages of mutual funds are:

Increased diversification towards many securities, which in turn reduces concentration risk
Transparency and Easy comparison through annual reports and periodic disclosures on the performance
The ability for investment participation in areas largely available to large investors, e.g., Investment in foreign markets, may not be directly accessible to individual investors.
Open-ended mutual funds can offer liquidity daily as the shares of the funds can be sold at a price equal to the NAV of the fund.

Despite many advantages, there are some drawbacks that one should take note of:

The predictability of income cannot be measured.
The opportunity for customizing the fund is relatively less.
As the fund has to adhere to the objectives of the fund, if an opportunity for gains is outside the purview, it cannot be pursued.

There are three primary structures of mutual funds:

#1 - Open-Ended Mutual Funds

Most mutual funds are open-ended, allowing investors to buy and sell the units at any time at the NAV (Net Asset Value). This NAV of the entire fund is calculated based on the price of the securities owned by the fund. Such a benefit offers a cushion to the investors for enhancing their returns during bullish markets or relevant liquidation during choppy market conditions.

#2 - Close-Ended Mutual Funds

These funds issue shares to the public only once during Initial Public Offering. The shares are listed on the stock exchange, and shares can be sold only to another investor in the market and not to the fund. The price investors can garner for their Investment may differ from the NAV and could either be at a 'Premium' or a 'Discount' of the NAV.

#3 - Unit Investment Funds

These trusts issue shares only once upon their creation, with the overall portfolio remaining unchanged. Such funds do not have the services of a professional fund manager. They generally have a restricted life span whereby the investors can redeem shares directly from the fund at any time or choose to wait until the trust's termination.

Also, have a look at the following articles for a deeper understanding –

What are Hedge Funds?

A hedge fund is an investment pool responsible for the private collection of funds using diverse and aggressive strategies to earn regular and above-normal returns for their investors. The investors are less in number but occupy a very healthy base. Investors from the affluent sections generally possess a very large risk appetite for absorbing losses, which can hamper the entire capital investment. As an entry criterion, the Offering Memorandum of a hedge fund states the minimum Investment required to be made by prospective investors. In most cases, this amount is not less than $10 million.

The fund is continuously managed by a hedge fund manager who is completely responsible for the investment's regular functioning and decisions, which will impact the fund's performance. Hedge funds with Assets Under Management (AUM) exceeding $100 million must be registered with the U.S. Securities and Exchange Commission. Additionally, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934.

Let us study some of the important benefits of these funds:

#1 - Protection From Downfall

Using various hedging strategies, hedge funds seek to protect profits and capital from declining markets. They can take advantage of falling market prices:

Utilizing tactics such as ‘Short Selling’ whereby they shall sell the securities with a promise to buy them back at a later date
Adjust the trading strategies according to the existing market conditions.
Extracting the benefits of wider asset allocation and diversification

Hence, e.g., if a portfolio includes shares of a media company and the cement sector and if the government offers some benefits to the Media sector but imposes an additional charge on the Cement sector, then in such cases, the benefits can outshine the possible declines in the cement sector.

#2 - Performance Consistency

The fund manager's role is to maximize the capital as much as possible and not beat a particular benchmark level and be content. Their funds are also involved, which should act as a booster in this case. Generally, managers do not have any restrictions on their choice of investment strategies and possess the ability to invest in any asset class or instrument.

#3 - Low Correlation

The ability to make profits in volatile market conditions equips them to generate returns that correlate little too traditional investments. Hence, it is not essential that if the market is falling, the portfolio has to be making a loss and vice-versa.

#4 - Cautious Decision Making

One of the unique and mandatory criteria is that the fund manager must be one of the large investors in the fund, which will make them cautious while considering relevant investment decisions.

The popular structures of Hedge funds are:

Master-Feeder: Perhaps, one of the most popular structures, this involves the funds to be invested by the investors into the feeder, which will then consolidate into the master fund. From this master fund, the fund manager will further invest in purchasing various assets. This is done to gain tax benefits as the feeder will allow investors from around the globe. Structurally, it is also easier to manage and report to investors.
Standalone Funds: These are individual funds whereby the investors make all the investments, and the fund manager will divert the funds from these standalone funds themselves. Generally, such funds do not get tax benefits but are relatively easier to report.
Fund of Funds: This is an investment strategy whereby one fund will further invest in other types of funds containing different underlying assets instead of direct investments in stocks and other securities.

Additionally, you may look at the following articles for in-depth understanding.

Mutual Fund vs Hedge Fund Infographics

Key Differences

A mutual fund is an investment vehicle whereby the funds are consolidated from several investors and managed by a professional fund manager for purchasing basket securities from the stock market. On the other hand, hedge funds are a portfolio of investments whereby only a few established investors are permitted to contribute to purchasing assets.
The objective of mutual funds is to offer returns over the market's risk-free rate of return. In contrast, hedge funds aim to offer the maximum possible returns from the Investment made.
The investors of mutual funds are retail investors (common people) who divert their limited disposable income into these funds with the hope of growing their money. In contrast, those making investments in hedge funds are generally HNIs or established individuals with a large appetite for risk. These investors make very large investments and desire very high returns in a quick time.
A professional fund manager manages both types of funds, but a mutual fund manager does not hold a substantial interest in the fund's working. Hedge fund managers have a mandate to hold a large share in the respective fund to generate a level-playing field on the part of the manager and prevent any decisions that can be detrimental to the overall interest of the fund.
Mutual funds are tightly regulated by the Securities exchange board of the respective country, which is not essential in the case of hedge funds.
Hedge funds offer information only to investors without any public disclosure of information. In terms of transparency, mutual funds must completely adhere to the yearly publishing of annual reports/balance sheets and the quarterly performance of assets. These disclosures must be made public with the statement sent to all the investors stating the overall performance.
The Management fees for mutual funds depend on the percentage of assets managed, whereas, for hedge funds, the fees are based on the performance of the assets.
Numerically, mutual funds have a large number of investors, with each having a limited investment . In contrast, hedge funds have a small number of very large investments by each investor .
The redemption of mutual funds is relatively easier (open-ended funds) to execute since the amount of funds is relatively less. In contrast, in hedge funds, the lock-in period is a long time (generally three years), due to which redemption is not possible. Subsequently, redemptions are made in blocks, and a 100% amount cannot be redeemed.

Comparative Table

Basis for Comparison	Mutual Funds	Hedge Funds
Meaning	These funds pool in savings from investors to prepare a basket of securities from the market at attractive costs.	A portfolio of investments whereby few established investors pool money to purchase assets.
Investors	Retail investors with limited disposable income	High net-worth individuals and firms with a high-risk appetite
Owners	Multiple Thousands	Few
Performance Fees	Based on the assets managed and charged as a Percentage	Performance-based
Management Style	Less aggressive and in line with objectives	Very aggressive
Regulation	Regulated by the Exchange (e.g., SEBI in India)	Limited regulation
Transparency	Annual reports and regular disclosure on the performance of assets	The information is offered only to investors.
Fund Manager Contribution	No mandatory involvement	A substantial investment of personal money

Conclusion

Both funds are known investment vehicles whose objective is to enhance the principal amount given by outsiders to grow money. The pace and strategies adopted by these funds make the difference in garnering the returns.

Mutual funds are targeted toward retail investors who are risk-averse but will prefer their money to grow at a constant pace over a long period. In contrast, hedge funds believe in extracting the maximum possible benefit from established investors' large investments. These investors want to make maximum possible gains and are ready to absorb equivalent risk accordingly.

Though the regulation and disclosures for both these structures differ, it all depends on the investor's investment objective and the amount of risk they are ready to absorb. The investor will accordingly have to structure their decision-making.