Mutual Fund vs Hedge Fund: Which One Should You Choose for Investment?

In this article know the difference between hedge funds and mutual funds and find out which one should you select for your investment needs:

What are Mutual Funds?

A mutual fund scheme, as the name suggests, is a fund that pools money from multiple investors and invests the collected corpus in various securities, such as stocks and fixed-income instruments. A mutual fund is required to be registered with the securities market regulator, the Securities and Exchange Board of India (SEBI), before it can collect funds from the public.

The investments are made in accordance with the investment objectives as disclosed in the scheme offer document. For instance, an equity mutual fund scheme will invest predominantly in stocks of listed Indian companies, while a debt mutual fund will invest a significant portion of its assets in debt and money market instruments. These funds follow well-defined asset allocation and investment limits as prescribed by SEBI.

Examples of mutual funds in India:

1. SBI Bluechip Fund

2. Parag Parikh Flexi Cap Fund

3. HDFC Mid-Cap Opportunities Fund

4. Nippon India Small Cap Fund

5. Kotak Multicap Fund

What are Hedge Funds?

Hedge Funds are private investment pools that use different strategies (hedging techniques) such as long and short positions, leverage, and derivatives to generate relatively higher returns compared to the market. They usually pool money from affluent investors as well as institutional investors. Hedge Funds fall under the Alternative Investment Funds (AIFs) - Category III of SEBI Regulations.

These funds can vary significantly from one another depending on the securities they invest in and the kind of strategies they employ to manage them. For instance, a hedge fund focused on long/short positions will aim to capitalise on both rising and falling stock prices by utilising a mix of long buying and short selling. Similarly, a fund focused on arbitrage opportunities will seek to identify discrepancies in cash and futures markets to benefit from the price differential.

Some of the hedge funds operating in India are:

1. Avendus Absolute Return Fund

2. Helios India Long/Short Fund

3. Alchemy Leaders of Tomorrow

4. Nippon India Undiscovered India Opportunity

5. Old Bridge AIF Long Term Equity Fund

How do mutual funds differ from hedge funds?

1) Investor profile

Mutual funds are open to investors across varying income levels. Investments can be started with a ticket size of as low as Rs 500, resulting in a large investor base.

On the other hand, hedge funds have a relatively limited investor base as they are only accessible to high-net-worth individuals and institutional investors, such as insurance companies and pension funds, having an investment corpus of at least a crore.

2) Portfolio strategies

Mutual Funds aim to generate steady growth of capital with moderate outperformance compared to the benchmark while minimising risk through judicious management of listed securities, predominantly equity and debt instruments.

Hedge funds aim to generate high returns by employing aggressive strategies such as short selling, derivatives, and leverage as well as investments in non-traditional assets such as unlisted securities, currencies, real estate, convertible securities, overseas securities, emerging themes, etc.

3) Regulation

Since Mutual funds are usually preferred by small-scale retail investors, they are subject to strict regulations and timely scrutiny by SEBI, which results in better accountability and ensures that the asset management companies prioritise investors' interests over chasing returns.

While hedge funds fall under the ambit of AIFs Category III of SEBI, they are not mandated to be registered with the market regulator. Accordingly, they are not tightly regulated as they are still in their nascent stages compared to global markets. As a result, they enjoy better flexibility with their investment strategies.

4) Transparency

In the case of mutual funds, all the data related to performance, risk ratio, expense ratio, portfolio, NAV, etc., is publicly available. Thus, investors have a clear understanding of the risk-reward matrix, making it easier to select the one suitable for their needs.

Meanwhile, since hedge funds are not heavily regulated, the transparency relating to disclosures and portfolio strategies is low.

5) Liquidity

Barring ELSS and Solution-oriented Funds that have a lock-in period, mutual funds across categories are highly liquid, allowing investors to buy and sell units as per their will on a daily basis based on the scheme's closing NAV of the day.

Hedge funds typically come with a lock-in period ranging from a few months to a few years and therefore, investors cannot withdraw their investment as and when they wish.

6) Management Fees

The expense ratio of mutual funds (which includes management fees and operational costs) can range between 0.8% and 2.25% of its daily assets depending on the type of scheme (equity, debt, other) and its AUM.

In the case of hedge funds, the overall fee is generally higher as they charge a management fee as a percentage of assets (usually less than 2%) as well as a performance fee which is a percentage of profits earned by the fund.

7) Taxation

Depending on the type of scheme, mutual funds may fall under equity or debt taxation. Watch this video to know how mutual funds in India are taxed:

Category III AIFs do not have a pass-through status, unlike mutual funds, due to their complex structure. This means that the tax is paid at the fund level on investors' behalf and the same is adjusted from the NAV before the profits are distributed. These funds pay taxes at the maximum marginal rate which can be as high as 40%, which can put certain investors at a disadvantage.

Mutual Funds vs Hedge Funds: Which one should you choose?

Due to the varying levels of regulations and transparency applicable as well as distinct strategies adopted by mutual funds and hedge funds, they cater to different investor profiles and risk appetites. Mutual funds are suitable for retail investors aiming for steady growth of capital over a period without taking undue risks. Meanwhile, hedge funds are suitable for seasoned investors having substantial investment corpus and having appetite for high risk to pursue potentially higher returns.

Mutual funds offer a simple, convenient, and regulated approach to creating wealth over the long run, while hedge funds use complex and aggressive strategies to outperform the market. While mutual funds too carry various risks, the degree of risk may be lower compared to hedge funds. Thus, investors should make an informed decision by evaluating their investment needs and understanding the fundamental difference between hedge funds and mutual funds.

High-net-worth individuals who are eligible to invest in both mutual funds and hedge funds should carefully assess their financial goals, risk tolerance as well as the tax implications under both options before investing.

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DIVYA GROVER is the co-editor for FundSelect, the flagship research service of PersonalFN. She is also the co-editor of DebtSelect. Divya is an avid reader which helps her in analysing industry trends and producing insightful articles for PersonalFN’s popular newsletter – Daily Wealth letter, read by over 1.5 lakh subscribers.
Divya joined PersonalFN in 2019 and has since then used stringent quantitative and qualitative parameters to analyse funds to provide honest and unbiased research to investors. She endeavours to enable investors to make an informed investment decision and thereby safeguard their wealth.

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.