One of the smartest moves any investor can make is to diversify their portfolio. Diversification means spreading your investments across different securities (such as stocks and bonds), and industries. This way, if one investment doesn’t do well, the overall risk to your portfolio is reduced. However, managing lots of different investments can get tricky rather quickly, especially if you don’t have the time or experience to keep track of them all.
Both mutual funds and hedge funds are types of investments that pool money from many investors to create a large, professionally managed portfolio, so these funds provide built-in diversification since they invest in a variety of securities. However, even though mutual funds and hedge funds share these similarities, they work very differently. Let’s take a closer look into mutual funds vs hedge fund to understand how each one works, how they differ, and how you can decide which option might be best for your goals.
What Are Mutual Funds?
Mutual funds are pooled investment vehicles offered by asset management companies (AMCs). They collect money from a large number of investors, which is then invested in a diversified portfolio of assets, such as stocks, bonds, gold, REITs, money market instruments, and other securities. Highly qualified professional fund managers with years of experience are put in charge of handling these funds. With their teams of analysts, the fund managers conduct in-depth research to select the best investment opportunities and manage the portfolio.
There are many different kinds of mutual funds available for investors to choose from. For example, debt funds are suitable for conservative investors whose primary motivation for investing is to preserve their capital. Equity mutual funds are attractive to long-term investors looking to grow their wealth. Funds such as ELSS are favoured by investors looking to reduce their tax liability.
In recent years the popularity of mutual funds in India has skyrocketed due to a variety of reasons. One doesn’t need a Demat account to start investing in mutual funds. Plenty of mobile platforms allow individuals to easily invest in a fund of their choice with just a few clicks. They also allow investors to take the SIP route, which means higher accessibility and the entry barrier for mutual fund investing is really low. Mutual funds come in a wide range of types as they offer options to suit investors with different risk tolerances and financial goals. Most mutual funds are highly liquid, so investors can redeem their investment anytime they’d like.
The mutual fund industry in India is regulated by SEBI (Securities and Exchange Board of India). Over the years SEBI has put in place stringent regulations to make mutual fund investing easier and safer for investors. Through these rules, they make sure that all AMCs and fund managers are accountable and transparent, and provide regular, accurate reports on fund performance and holdings. At all times, investors can stay updated on the details relating to their funds. They know exactly where their money is going and how it’s performing.
What Are Hedge Funds?
Hedge funds, too, follow the same pooled investment structure as mutual funds. However, these funds are only offered privately, meaning they are only available to a select group of investors, such as accredited investors, high-net-worth individuals, and institutional investors. Consequently, hedge funds require a very high minimum investment amount.
Since HNIs often have a higher investible surplus, they are allowed to invest in exclusive investments like hedge funds, which are riskier than mutual funds. Managers handling these funds use advanced investment strategies, such as derivatives, short selling, leverage, and arbitrage, to maximise returns. These techniques, as well as the underlying assets of a hedge fund, come with higher risks, which is why such funds are suited for aggressive, experienced, high-net-worth investors.
Hedge funds were introduced by SEBI in 2012, and were classified as Alternative Investment Funds under Category III. SEBI does not regulate hedge funds as heavily or as directly as it regulates mutual funds. The regulations for alternative funds are much more flexible, which is why hedge fund managers can pursue a broader, more complex range of investment strategies. These allow managers to take much more aggressive positions in the market in search of higher returns, but they also mean they come with much higher risk.
Key Differences Between Mutual Funds and Hedge Funds
The difference between hedge funds and mutual fund is summarised below:
| Factor | Mutual Funds | Hedge Funds |
| Investor Type | Mutual funds are open to the public and are offered to retail investors. | Hedge funds are offered exclusively to accredited investors, like HNIs and institutional investors. |
| Management | Most mutual funds are actively managed, meaning fund managers aim to earn returns higher than a benchmark. Some mutual funds like index funds are managed passively. | Hedge funds are actively managed. |
| Regulation | SEBI heavily regulates the mutual fund industry in India to protect the interests of retail investors. | Hedge funds are not regulated as strictly by SEBI. |
| Liquidity | Most mutual funds are open-ended, so their units can be easily bought or sold on a given business day. Closed-ended funds do not offer as much liquidity. | Hedge funds often come with lock-in periods, which limits the liquidity they offer. |
| Investment Strategy | Investment strategy depends on the fund type and fund manager, but overall the use of advanced investment techniques is limited due to regulations. | Hedge fund managers use complex and aggressive investment techniques, such as short selling and derivatives to earn high return and minimise risk. |
| Risk | Mutual funds come with various risk levels ranging from very low (debt-focused funds) to very high (equity-oriented funds). | Hedge funds chase very high returns through advanced investment strategies so they carry very high risk. |
| Fees | Mutual funds can charge an expense ratio between 0.5% and 2%. Some funds may even charge an exit load in case investors prematurely redeem their units. | Charges associated with hedge funds are relatively much higher, as the total fees include a management fee as well as a performance fee. |
| Minimum Investment | Investors choosing to invest through systematic investment plans can start with as low as Rs. 500 in most funds. | Hedge funds set a high ticket size (minimum Rs. 1 crore) to make sure that only accredited investors participate. |
Investment Strategies: Mutual Funds vs Hedge Funds
Regulation plays an important role when comparing mutual fund vs hedge fund strategy because it dictates what kinds of investments and tactics each fund can use. For mutual funds, these regulations are quite strict, as their purpose is to protect the investors. On the other hand, hedge fund managers use more high-level and higher-risk strategies to earn returns. For example, they may take short or long positions in securities, use arbitrage strategies, leverage funds, or make bets on interest rates and currencies. While these increase the potential for returns, the risks also rise.
Advantages and Disadvantages: Hedge Funds vs Mutual Funds
Let’s have a look at the advantages and disadvantages of mutual funds vs hedge funds to get a clearer picture:
Mutual Fund Advantages And Disadvantages (Compared to Hedge Funds)
| Advantages | Disadvantages |
| Mutual funds have lower minimum investment amounts, making them more accessible to retail investors. | The return potential offered by mutual funds isn’t as high as hedge funds. |
| The Indian mutual fund industry is very well regulated by SEBI, so AMCs have to adhere to strict rules to ensure transparency and investor protection. | Due to SEBI regulations, the more aggressive investment strategies are restricted for mutual funds. |
| Most mutual funds are open-ended, so investments can be redeemed quickly without any additional charges or penalties. |
Hedge Fund Advantages And Disadvantages
| Advantages | Disadvantages |
| Aggressive investment strategies such as derivatives and short selling can increase returns significantly. | Complex investment strategies can result in significant losses, which make hedge funds very risky. |
| Due to limited regulation, hedge fund managers are free to pursue more flexible strategies. | The minimum amount required to invest is very high, so only HNIs and institutional investors can take part. |
| Hedge funds charge higher fees compared to mutual funds (management fee as well as performance fee). | |
| Not as liquid as mutual funds. |
Who Should Invest in Mutual Funds?
Mutual funds are suitable for retail investors looking to achieve their short, medium, and long-term financial goals. Mutual funds can be classified into many types, so they can meet the needs of a wide variety of investors. For example,
- Investors with long-term goals like building a retirement fund and high-risk tolerance can invest in equity funds such as large, mid, and small-cap funds.
- Investors looking to create a stream of income, like retirees, can invest in income funds.
- Conservative investors or investors with high liquidity needs can turn to debt funds such as liquid funds to preserve their capital.
- Investors looking to save tax can invest in Equity Linked Savings Schemes, which, according to Section 80C of the Income Tax Act, offer a tax deduction of up to Rs. 1.5 lakh.
Investors who cannot invest a large lump sum amount should also consider investing in mutual funds through SIPs. Through regular and fixed contributions, investors can take advantage of compounding returns and rupee cost averaging to create wealth in the long term.
Who Should Invest in Hedge Funds?
Hedge funds are only offered privately to accredited investors, so the ticket size is big. For example, HNIs can invest in hedge funds with a minimum investment amount of Rs. 1 crore. Hedge fund managers use advanced techniques to generate returns, so investors should also be adept at investing and should understand complex financial instruments and strategies. The potential returns are very high, but so is the risk. The fee associated with hedge funds is also significantly higher compared to mutual funds, so HNIs with sufficient experience, investible surplus, and a high-risk tolerance should consider investing in hedge funds.
Conclusion: Mutual Funds vs Hedge Funds – Which is Right for You?
Even though mutual funds and hedge funds share some similarities, the investor base they aim for is vastly different. Investors choosing between mutual fund or hedge fund should consider their financial goals, risk tolerance, and investment horizon. High-net-worth individuals have a large investible surplus, touching several crores. Not just that, these investors are more experienced in financial markets and understand the complex strategies employed by hedge fund managers. They have a very high-risk appetite and can commit large amounts to earn higher returns, so accredited investors can consider investing in hedge funds.
Mutual funds, on the other hand, are more suitable for novice and experienced retail investors looking to achieve short, medium, or long-term financial goals. They allow investors to start with smaller amounts through SIPs. Over time, these fixed and regular contributions can help investors earn significant returns due to compound interest. Mutual funds are well-regulated by SEBI, which ensures transparency and protects the interests of retail investors.
