Difference between hedge fund and mutual fund ?

Difference between hedge fund and mutual fund

When we refer to hedge funds the first image that comes to our minds is of extremely smart fund manager sitting in some corner of the world and moving billions of dollars across asset classes. Hedge funds are closed clubs and hence not much is known about them or their investment strategies.

Are there hedge hedge funds in existence in India?

In India a number of large hedge funds operate as Foreign Portfolio Investors and these include names like Amansa, Helios etc. Most of these hedge funds either directly or they operate as P-Notes of large FPIs. This is largely different from the mutual funds that we typically invest in for the sake of our long term goals.

The world of mutual funds is much simpler while the world of hedge funds is a lot more esoteric. Let us understand how are hedge funds different from mutual funds? The difference between hedge fund and mutual fund is not only about the nature of investors but also the way the funds are managed.

How is the structure of a mutual fund differenct from a hedge fund?

We first take a look first at the nature of these two funds. A mutual fund is essentially a trust which pools the savings of millions of small and medium sized retail investors and invests this money in equity and debt. The hedge fund, on the other hand, is a portfolio of investments in which only a few wealthy and qualified investors are allowed to invest.

Let us also talk about the minimum investment required. Normally, the minimum investment required in a hedge fund structure is very high and would run into millions of dollars. This keeps most retail investors out of the purview of hedge funds. The typical investors in hedge funds are the institutional bodies like pension funds, endowment funds, sovereign funds, family offices and high net worth individuals.

How is the performance of a mutual fund and a hedge fund evaluated?

There is a very important difference between hedge funds and mutual funds in the way the performance is evaluated. Let us look at the mutual funds first. These Mutual funds are relative performance funds. What this essentially implies is that the returns of a mutual fund are evaluated with reference to the performance of the index or the peer group. Therefore, if the market has fallen 20% in the last year, then a mutual fund that has fallen by 12% will be considered a good performer.

The situation is very different when it comes to hedge funds. That is because, hedge fund investors are absolute return investors and they don’t care about how indices have done. Hedge fund managers are expected to be fleet-footed enough to shift asset mix at short notice. Being absolute return fund with focus purely on absolute returns, these hedge fund managers have a lot more leeway. For example, the hedge fund managers are permitted to trade on the long side and also on the short side. Therefore, they are judged on the absolute returns that they generate irrespective of the performance of the benchmark indices. This is an important area of distinction between hedge funds and mutual funds.

Is there a difference in the asset mix of mutual funds and hedge funds?

The way the mutual fund is managed and a hedge fund is managed also differs vastly. Here is what you must know. For example, mutual funds are managed within very well laid out guidelines and are subject to controls as well as a board of trustees that ensures the objectives of the fund are not compromised. There are clear restrictions on mutual funds when it comes to asset mix, concentration and in allocation to derivatives.

Just to cite an example, mutual funds in India can only use derivatives to hedge underlying exposures. Also the asset classes they can invest in is limited. Hedge funds have no such restriction. They can run a long/short fund or a pure short fund or an opportunities fund or even a 1/x fund. They can also run macro funds or hedge funds for distressed assets. Hedge funds are allowed to invest in derivatives, structured products, real estate, global assets, art and even wines. They have a really huge choice of investment options.

Which is more transparent and better regulated between MFs and hedge funds?

Mutual funds being closely regulated and monitored are a lot more transparent when it comes to adequate disclosures. There is also a vast difference in how the fees are charged in both these funds. For example, a mutual fund is allowed to charge a fixed percentage of the assets under management (AUM) as the fee, which is captured as the total expense ratio or TER. All these details have to be disclosed by the mutual funds for transparency sake.

Hedge funds, on the other hand, not only charge a fixed fee but also charge a performance fee on top of that. For example, if the actual returns on a hedge fund cross a hurdle rate then there is an additional kicker thrown in for the hedge fund manager. That means; costs in hedge funds can be quite prohibitive, unless the hedge is able to sustain absolute returns year after year. Hedge funds are not regulated closely since they are for large investors. Hence hedge funds can get away with limited disclosure.

Where does mutual fund score over hedge funds in disclosure of information?

Let us not miss out the issue of transparency. Hedge fund operate like extremely closed clubs. More often than not, even the entry into a hedge fund is by invitation only. Details of the fund strategy, its asset mix, the returns generated etc are only made available to the investors in the fund and that too on a limited basis.

Mutual funds are required by SEBI to make its fund fact sheets and its performance data public on the website. Even if you are not the investors in a mutual fund, you can access all this information from the website of the mutual fund. In terms of disclosure and transparency mutual funds surely score over hedge funds.

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