Difference Between Mutual Fund and Hedge Fund
Both the mutual funds and the hedge funds are the investment funds where mutual funds are the funds which are available for the purpose of the investment to the public and are allowed for trading on the daily basis whereas in case of the hedge funds investments by only the accredited investors are allowed.
Each individual or organization desires their money to grow at a rapid pace for which they have to make investments. A variety of investments exists; some offer larger return but may have to bear larger risks and vice-versa. In this regard, we will go through the investment options pertaining to mutual funds and hedge funds with the key differences between them.
Both funds are an investment vehicle that will pool in money from various investors with the objective of multiplying them in a quick time and proportionate level of risk depending on the appetite of the investors. Both these funds are managed by a professional fund manager.
Let us understand each of the options in details with the differences –
What are Mutual Funds?
A mutual fund is an investment vehicle that will pool money from multiple investors for purchasing securities. These funds are generally risk-averse in nature and focus on the regular increase in the Investment made in the stock market. They are regulated by the exchanges, and hence it is mandatory for them to issue a prospectus which will clearly state out the objectives of the fund and the strategies to be implemented by them. Accordingly, they have to abide by the same, which in turn shall infuse confidence in the investors.
Retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making. who have limited savings for investment purposes, in turn, become inclined towards this area of Investment. Such funds offer limited returns but, in turn, more security in the principal Investment which 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 ambits of the law. It is not mandatory for the fund manager to include their personal 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 periodical disclosures on the performance
- The ability for investment participation in areas largely available to large investors e.g., Investment in foreign markets, which may not be directly accessible to individual investors.
- Open-ended mutual funds can offer liquidity on a daily basis as the shares of the funds can be sold at a price equal to the NAV of the fund.
Despite some many advantages, there are some drawbacks which 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 of the mutual funds are open-ended, which permits investors to buy and sell the units at any point in 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.Initial Public Offering.An initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange. 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 which investors can garner for their Investment may differ from the NAV and could either be at a ‘Premium’ or at a ‘Discount’ of the NAV.
#3 – Unit Investment Funds
These trusts issue sharesIssue SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet. only once upon their creation with the overall portfolio also remaining unchanged. They generally have a restricted life span whereby the investors can redeem shares directly from the fund at any point in time or can choose to wait until the termination of the trust. Such funds do not have the services of a professional fund manager.
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What are Hedge Funds?
A hedge fund is an investment pool that is responsible for the private collection of funds with the use of diverse and aggressive strategies for the purpose of earning regular and above normal returns for their investors. The investors are less in number but occupy a very healthy base. Investors are generally from the affluent sections possessing a very large risk appetite for absorbing losses, which can hamper the entire capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.. As an entry criterion, the Offering Memorandum of a hedge fund states the minimum Investment required to be made by prospective investors, and 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 regular functioning and decisions of Investment, which will have an impact on the performance of the fund. Hedge funds with Assets Under Management (AUM) exceeding $100 million are mandated to 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
Hedge funds seek to protect the profits and the capital amount from declining markets by using various hedging strategies. 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 to the trading strategies according to the existing market conditions.
- Extracting the benefits of wider asset allocationAsset AllocationAsset Allocation is the process of investing your money in various asset classes such as debt, equity, mutual funds, and real estate, depending on your return expectations and risk tolerance. This makes it easier to achieve your long-term financial goals. and diversification
Hence, for 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
Generally, managers do not have any restrictions on their choice of investment strategiesInvestment StrategiesInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on. and possess the ability to invest in any asset class or instrument. The role of the fund manager is to maximize the capital as much as possible and not beat a particular level of benchmark and be content. Their individual funds are also involved, which should act as a booster in this case.
#3 – Low Correlation
The ability to make profits in volatile market conditions equips them to generate returns that have little correlation to traditional investments. Hence, it is not essential that if the market is falling down, 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 structure, this involves the funds to be invested by the investors into the feeder, which will then consolidate to the master fund. It is from this master fund; the fund manager will further invest in purchasing various assets. This is done to gain tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place. as the feeder will allow investors from around the globe. Structurally, it is easier to manage and report to the investors as well.
- Standalone Funds: These are individual funds whereby all the investments are made by the investors, and the fund manager will divert the funds from these standalone funds itself. 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 assetsUnderlying AssetsUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. instead of direct investments in stocks and other types of securities.
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Mutual Fund vs Hedge Fund Infographics
- A mutual fund is an investment vehicle whereby the funds are consolidated from several investors 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 the purchasing of assets.
- The objective of mutual funds is to offer returns in excess of the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk. of return, which is being offered by the market, whereas hedge funds aim to offer maximum possible returns from the Investment made.
- The investors of mutual funds are retail investors (common man) who divert their limited disposable incomeDisposable IncomeDisposable income is an important mechanism to measure household incomes, and includes all sorts of income such as wages and salaries, retirement income, investment gains. In other words, it is the amount of money left after paying off all the direct taxes. in these funds with the hope of growing their money, whereas those making investments in hedge funds are generally HNI’s or established individuals with a large appetite of risk. These investors make very large investments and desire very high returns in a quick time.
- Though both types of funds are managed by a professional fund manager, a mutual fund manager does not hold a substantial interest in the working of the fund. 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.
- In terms of transparency, mutual funds have to completely adhere in the form of yearly publishing of annual reports/balance sheet in addition to the quarterly performance of assets. These disclosures have to be made public with the statement being sent to all the investors stating the overall performance. Hedge funds offer the information only to the investors without any public disclosure of information.
- 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 [as low as Rs.500 ($8.33)], whereas hedge funds have a small number of very large investments by each investor [minimum $10 million Investment].
- The redemption of mutual funds is relatively easier (open-ended funds) to execute since the amount of funds is relatively less and whereas 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.
|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|
|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 reportsAnnual ReportsAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company's performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements. 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|
Both funds are known investment vehicles whose objective is to enhance the principal amount given by outsiders with the aim of growing money. It is the pace and strategies adopted by these funds, which make the difference in garnering the returns.
Mutual funds are targeted towards the retail investors who are risk-averseRisk-averseThe term "risk-averse" refers to a person's unwillingness to take risks. Investors who prefer a low-return investment with known risks to a higher-return investment with unknown risks, for example, are risk-averse. but will prefer their money growing at a constant pace over a long period of time, whereas hedge funds believe in extracting the maximum possible benefit from the very large investments made by established investors. These investors want to make maximum possible gains and accordingly are ready to absorb equivalent risk.
Though the regulation and disclosures for both these structures differ, it all depends on the investment objective of the investor and the amount of risk they are ready to absorb. The investor will accordingly have to structure their decision making.
This has been a guide to Hedge Funds vs Mutual Funds. Here we discuss the top differences between them along with infographics and comparative table. You may read other suggested articles from the below list –