The financial sector is constantly evolving. The formation of investment vehicles to make money for both those who design them and those who purchase them is a crucial component of that process. There might be some financial terms or jargon with which the general public might not be familiar except the industry experts. In this article, we will discuss two such terms that are contrasting each other in their meanings, they are- ‘Hedge Fund’ and ‘Mutual Fund’. They appear to be very similar in their initial appearance because both rely on investors building a fund pool and giving that fund pool to a fund manager to manage. The manager is in charge of deciding where and in what ways the money is invested to provide returns for the investor. Diversification is a component of each fund's investment strategy. Each person or business wants to invest their money to increase rapidly. There are various investments; some give higher rewards but may also come with higher dangers, and some might have fewer dangers than others.
Hedge Fund - A fund made up of a limited partnership made up of individual investors is referred to as a hedge fund. These investors' money is managed by professional fund managers who employ a range of strategies to generate returns on investments that are above average. Hedge fund managers have a history of employing strategies like leverage to generate significant profits. Investing in hedge funds is frequently thought of as dangerous, with high stakes and an emphasis on rich customers. Equity, fixed-income instruments, and investments based on goals that are influenced by specific events are all possible investments for hedge funds.
Mutual Fund- Mutual funds are a kind of investment vehicle that combines the money of numerous individuals to buy various kinds of securities, including equities, bonds, and other investment instruments. A qualified fund manager oversees the management of the pooled funds and is in charge of selecting investments on behalf of the fund's investors.
Hedge fund vs Mutual fund
The key difference to remember between these two financial terms is that ‘Hedge funds’ are usually considered private investments that are available only for higher wealthy clients or accredited investors. They are known to be involving higher- risk strategies for a higher return. On the contrary, Mutual Funds are known to pool funds available for the general public and daily trading, any individual can invest in these types of funds, but they might not have as much risk level like a Hedge fund. It also provides a wide range of choices for its users.
Difference between the Hedge fund and Mutual fund in Tabular Form
|Parameters of comparison||Hedge fund||Mutual fund|
|Definition||A portfolio of investments known as a hedge fund is when a select group of affluent, qualified individuals pool their funds to purchase assets.||A mutual fund is a trust that uses the combined savings of multiple participants to buy a diverse selection of securities at a discount. It is open to the general public as well and not only to a specific group.|
|Return||In this fund, there is an absolute return available.||This fund seeks relative returns on the investment.|
|Investors||Most highly accredited wealthy individuals or organizations are willing to take risks||Retail investors or the general public with fixed income.|
|Owners||It is commonly owned by only a few individuals due to the high risk.||It is owned by thousands of people or retailers as it relatively possesses lower risks.|
|Regulation||It is not regulated by an organization and has limited regulation.||It is strictly regulated by organizations like SEBI, etc.|
|Operation||It is aggressively managed or operated.||It is less aggressively managed.|
|Fees generated||It is based on the performance.||It is based on the percentage of managed assets.|
|Clarity/transparency||The information is only provided to private investors.||Yearly reports are published along with semi-annual reports on the performance of assets.|
|Contribution of fund manager||A substantial amount of personal money is involved.||There is no such mandatory contribution.|
What is a Hedge fund?
A hedge fund is a type of investment association that exclusively accepts investments from an exclusive set of high-net-worth individuals. The fund requires a slightly large initial contribution as a minimum. The fund is exempt from restrictive rules. The risk component is particularly high in hedge funds, which is why the fund management employs risky techniques like short selling, options trading, investing in stocks at significant discounts, anticipating a specific occurrence, etc. The fund, on the other hand, employs those financial tools that reduce risk and boost returns. These types of funds do not have restricted strategies which allows them to create positive and outsized returns for the investors. A hedge fund's main objective is often to outperform more conventional investment vehicles in terms of returns while simultaneously guarding against potential adverse hazards. In a hedge fund, there are only a limited number of investors involved. In the sector of investment strategies, they can adopt more risky ones as they are not regulated by a regulating body that allows them to invest in any market like- cryptocurrency, real estate, etc.
Typically, a hedge fund charges two types of fees- Performance and management fees. Similar to a mutual fund's management fee, a management fee is charged. The fund deducts an expense ratio from the assets under management each year, which is normally 2%. Whereas, the performance fees fluctuate based on the performance of the fund and are typically 20% of gains. As a result, if the fund grows by 10% in a year, it will keep 2% of the profits (or 20% of the gains) and retain the remaining 80% in the fund. There is no performance charge if the fund loses money, but the investors are still responsible for the management fee.
Types of hedge funds:
- Domestic hedge fund- It is the type that is only available to the citizens of a particular country who pay the taxes of the same country.
- Offshore hedge fund- Offshore Hedge Funds only invest in international businesses, as well as other businesses and industries, frequently in nations with low tax rates. NRIs with significant net wealth frequently make these investments.
- Global macro funds- These are actively managed funds that make bets on wide market changes brought on by governmental or economic developments. Investing options for fund managers include equities, bonds, currencies, commodities, derivatives, and other assets. To make choices, they would examine geopolitical developments as well as global monetary and fiscal strategies.
- Equity hedge fund- An equity hedge fund, which may invest in profitable firms and act as a hedge against declines in equity markets by selling short expensive equities or stock indices, may be global or nation-specific.
- Relative value fund- These kinds of investments rely on negotiations, which is the practice of attempting to profit from slight price discrepancies between comparable or identical securities.
- Activist hedge fund- This kind of hedge fund would function as an activist shareholder by actively participating in the management of the firms in which it invests. Since the hedge fund may then compel fundamental changes to raise the target business's valuation, the activism typically happens after it has acquired a majority stake in a company. This can entail replacing the board of directors or reducing expenses.
What is a Mutual Fund?
A mutual fund is a type of financial instrument that collects funds from many different individuals to buy securities. These funds tend to be risk cautious and concentrate on the consistent growth of stock market investments. They must publish a prospectus that outlines the goals of the fund and the tactics that will be used since exchanges regulate them. It is publicly open for anyone to invest in, unlike the hedge fund which was only limited to a certain group of wealthy individuals. Individual investors who have less money set aside for investments are consequently more willing to participate in this sector. Such funds provide modest returns, but in exchange, the main investment is protected to a greater extent. The funds are administered by a qualified fund manager, who is required to maximize returns while staying within the bounds of the prospectus. The investment made by the fund manager is not required. It has more transparency as annual and semi-annual reports are published after regulation by SEBI. It also has a vast diversification for investment securities which lowers the risk. Compared to hedge funds, mutual funds are typically thought of as safer investments. This is due to fund managers' restricted use of riskier tactics like leveraging their holdings, which can boost returns but also raise instability.
Just like a hedge fund a mutual fund also charges a management fee which usually ranges from 1% and 2% of assets in management. The performance of the mutual fund determines the return; if the value increases, the return rises; if the value decreases, the return may decrease. Each unit holder receives a share of net income and capital gains proportionate to their capital.
Types of mutual funds:
- Actively managed vs passive funds- Mutual funds that are actively managed aim to outperform their benchmark index by carefully choosing which securities to buy and sell. By modeling a portfolio based on the benchmark index, passive funds, also known as index funds, just attempt to duplicate the returns of the index used as a benchmark. The fund may occasionally just purchase all the securities in the index.
- Open-ended vs closed-ended funds- There is no restriction on how many shares open-ended funds can issue. Shares are simply purchased by investors, and the fund management then divides up fresh inflow among the relevant securities. Due to the limited number of shares in closed-ended funds, the portfolio manager is not affected by inflows or withdrawals. You must locate a buyer or seller on the market as a whole if you want to buy or sell shares.
- Equity funds- These are investment funds that purchase equity stocks and company shares. These funds are regarded as having a high risk/return profile. Infrastructure, fast-moving consumer products, and banking are just a few examples of specialty funds that might be included in equity funds.
There are several types of mutual funds but broadly we can classify them under main categories that are stock funds, money market funds, bond funds, and target-date funds.
- Stock funds- As the name refers, this fund typically invests in stocks or equities. The market capitalization, size, and growth potential of the equities that make up a fund can all be used to categorize it. The phrase "value fund" refers to a method of investing that seeks out high-quality, slow-growing businesses that are undervalued by the market.
- Bond funds- The fixed-income group of mutual funds includes those that produce a minimum return. A mutual fund that invests in fixed-income securities, such as corporate or government bonds or other debt instruments, focuses on investments that have a fixed rate of return. The shareholders of the fund benefit from the interest income generated by the fund portfolio.
- Money market funds- The majority of the short-term debt instruments in the money market are Treasury bills, which are secure, risk-free investments. The principal is insured, but an investor won't get substantial earnings.
- Target-date funds- Target-date funds are designed to maximize returns for investors by a given date. In general, the funds are made to make profits in the early years by concentrating on riskier growth equities, then they try to hold onto those gains as the goal date gets closer by leaning towards more secure, more conservative picks.
Main differences between Hedge funds and mutual funds (in points)
- Only a select group of authorized investors are permitted to pool their funds to purchase assets through a hedge fund, which is referred to as a portfolio investment. A professionally operated investment vehicle known as a mutual fund pools the money from several investors to buy securities.
- The hedge funds chase for absolute returns whereas mutual funds seek for relative returns.
- Hegde funds are aggressively managed as they have a greater risk for returns to obtain high returns, while mutual funds are less aggressively managed.
- Since mutual funds are open to everyone it can have thousands of owners, whereas hedge funds only have a few owners as they are limited to certain wealthy individuals.
- In hedge funds mostly highly accredited investors or organizations willing to take high risks are involved. In mutual funds, retail investors invest in the funds.
- There is no strict regulation for the hedge funds but mutual funds go through annual and semi-annual regulation by SEBI and other organizations that publish annual reports.
- The fraction of assets handled in mutual funds determines the management fees. In contrast to hedge funds, whose management fees are determined by the performance of the assets.
- For mutual funds, annual reports are published and asset performance is every half year which shows its transparency, but hedge funds only report to private investors and there is no public display of the assets.
These both types of funds are a great opportunity for investors to invest according to their income levels. If you have a high-income level you can opt for hedge funds whereas, if you are a normal-income individual or a retail investor you can choose mutual funds to invest in. Both funds are well-known investment vehicles whose goal is to increase the primary sum contributed by outsiders to grow money. The speed and approaches used by these funds make a difference in the results.
Mutual funds are mainly targeted at the general public or retail investors with a fixed income level and those who are unwilling to take a high risk and want their funds to grow over time.
Hedge funds are targeted toward wealthy established clients or organizations that are willing to face high risks. These investors focus on gaining maximum profits and benefit out of their invested funds and bear the risks along with it.
In this article, we discussed the main differences between hedge and mutual funds, their basic definitions, and the different types of funds of each kind. This article gave you an overview of the usage and concept of hedge and mutual funds along with their distinctions.