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Investing as an individual poses challenges, spanning limited capital to a need for more tools to evaluate opportunities. However, collective investment schemes like mutual funds and hedge funds pool resources, allowing everyday investors unified access to elaborate strategies beyond individual reach.
In this article, we will learn the common goals, mutual and hedge funds differ substantially across investor type, regulation, assets, risk, and other key areas. Evaluating critical distinctions grants clarity on suitable options.
Defining Mutual Funds
Mutual funds represent publicly available investment funds aggregating money from retail and institutional investors into a collective pool. Fund managers then invest across diverse baskets of securities like stocks, bonds and money market assets based on stated fund objectives. Investors purchase shares representing fractional ownership of total holdings.
As regulated instruments under SEBI in India, mutual funds focus on broadly diversified, longer-term focused strategies targeting accessibility and ease for common investors. Offerings span equity, debt, hybrids, index tracking, and more. Catering to wider audiences through banks and brokerages, mutual funds carry modest minimum investments and asset management fees.
Defining Hedge Funds
Mutual funds are open to the public, while hedge funds are exclusive private partnerships for accredited or institutional investors. Hedge fund managers aggressively use unconventional trading approaches to achieve higher returns with higher risks.
The investment amount is a minimum of Rs. 1 crore with the “2 and 20” compensation model: 2% of assets and 20% of profits above agreed-upon hurdles. Hedge funds in India are Category III Alternative Investment Funds that invest in securities, commodities, currencies, and exotic instruments.
Their tactics include concentrated bets, elaborate hedging, and a global scope. Regulatory oversight for hedge funds is minimal compared to mutual funds, which can be freeing or risky.
What is a Hedge Fund vs Mutual Fund
Accessibility forms a core differentiation between mutual and hedge funds. Mutual fund participation stays open to everyday retail investors – potentially anyone with some risk capital seeking professional management. This facilitates public ownership.
Meanwhile, hedge fund eligibility restrictions limit ownership to qualified ultra-high-net-worth individuals or institutions alone. Their sophisticated strategies and love of complexity cater to specialised participants only. Mutual funds welcome the masses. Hedge funds court whales.
Hedge Fund vs Mutual Fund Performance
Just as appeal diverges by wealth class, so too do employ tactics chasing hedge fund vs mutual fund performance the returns, including:
- Asset Allocation: Mutual funds in India require adherence to SEBI asset selection rules, formulating diversified baskets carrying lower standalone volatility. Hedge fund flexibility allows more concentration around narrow opportunities, greatly elevating risk.
- Leverage Usage: Unlike mutual funds avoiding debt, hedge funds actively utilise leverage, amplifying selected exposures. This compounds both gains and losses when betting correctly and incorrectly, respectively. The risk roulette wheel spins faster.
- Profit Objective Time Horizons: The typical mutual fund maintains longer-term investment horizons targeting benchmark outperformance over the years. Hedge funds prioritise immediate gains even at the expense of short-term focus, jeopardising enduring growth. Goals differ.
- Liquidity & Withdrawal Terms: Open-end mutual fund units facilitate easy entry/exit flexibility with daily liquidity, barring exceptions. Many hedge funds incorporate redemption restrictions or impairment charges discouraging quick flight. Lock-up periods span months or years.
Evaluating approach differences, including leverage limits, liquidity barriers, and governance constraints, paints a portrait of the institutional contrasts at play. Objectives themselves diverge considerably.
Tax Considerations on Hedge Funds vs Mutual Funds vs ETFs
While both collective investment vehicles provide skilled management towards profit generation, taxation on those earnings differs:
- Mutual Fund Taxation
As pass-through entities, the mutual funds themselves pay zero taxes directly. Only individual investor-level capital gains or dividends face personal levies per holding period. Funds avoid double taxation events, easing investor burdens.
- Hedge Fund Taxation
Unlike mutual funds, hedge funds as Category III Alternative Investment Funds suffer significant taxation at the fund level before investors receive allocations. Any annual earnings beyond ₹5 crores get deducted upwards of 40% straight from the fund asset base regardless of what individual investors then owe personally on the remainder distribution. This dynamic severely hampers post-fee and post-tax returns.
- ETF Taxation
As predominantly passively managed index-tracking instruments, ETFs require little active trading internally. This results in a lower likelihood of realised taxable capital gains year-on-year at the fund itself. Investors appreciate getting allocated a larger piece of the overall earnings pie after modest fund-level reductions. Lower embedded taxation expenses benefit investor proceeds.
In essence, while creative hedge fund strategies promise tremendous pre-tax returns seducing investors, their post-tax net yields after fund taxation often sharply lag more tax-efficient mutual funds and ETFs – despite ultra-high fees. So, cautious evaluation should weigh these dynamics against headline pre-tax projections that obscure ultimate take-home impacts.
Comparing Key Attributes of Hedge Funds, ETFs, and Mutual Funds
| Criteria | Hedge Funds | Mutual Funds | ETFs |
| Return Objective | Absolute returns, regardless of broader markets | Relative returns aiming to beat benchmarks | Relative returns tracking indexes |
| Management Approach | Actively managed using unique strategies | Mostly actively managed by analysts | Passively managed mirroring indexes |
| Fee Structure | Performance-based fees tied to profits | Annual % of assets under management | Lower expense ratios averaging 0.5% |
| Pricing | No daily quoted prices, valued periodically | Priced daily based on NAV per unit | Intra-day exchange trading, like stocks |
| Transparency | Data only selectively shared with investors | High transparency via regulated disclosures | Fully transparent daily holdings disclosure |
| Regulation Levels | Little oversight relative to alternatives | Heavily regulated by SEBI on multiple fronts | SEBI regulations protect shareholders |
| Investor Liquidity | Low liquidity, lock-up periods restricting exit | Daily open-ended redemption abilities | Intra-day exchange trading liquidity |
| Participants | Qualified ultra-high-net-worth individuals | Open to everyday retail public participation | Retail investors buy/sell like stocks |
| Fractional Ownership | No – minimum ticket sizes apply | Yes – units allow fractional ownership | Yes – shares trade in any quantities |
| Taxation Differences | Significant taxation is applied at a fund level | Pass-through entity not directly taxed | Relatively low tax liability for investors |
Evaluating structural and strategic differences between available pooled investment vehicles enables better-informed asset allocation tailored to needs.
Conclusion
Mutual funds prioritise accessibility, diversification and simplicity, pursuing indexed or benchmark-beating equity/debt returns over longer periods. At the same time, hedge funds embrace complexity courting whales with elaborate tactics, amplified risk, and constraints chasing absolute profits over market-agnostic gains.
FAQs
The main differences lie in investor eligibility, assets invested in, risk tolerance, fees charged, liquidity terms, transparency, and taxation – shaping divergent objectives between the available mutual funds versus exclusive hedge fund partnerships.
Indian mutual funds utilise conventional long-only, buy-and-hold approaches adhering to SEBI diversification rules to achieve benchmark-tied returns over longer periods. Strategies match moderate risk appetites.
Hedge funds embrace unconventional levers like short-selling, derivatives, leverage, arbitrage, global assets, and concentrated bets, chasing amplified gains without chasing indexes. Higher risk/fees exist.
Mutual funds court mass retail participation with investment minimums starting around ₹500, whereas hedge funds demand a ₹1 crore entry fee given the complexity of servicing ultra-high net worth whales alone.
Mutual funds enjoy pass-through taxation, with investors paying. But hedge funds face over 42% levies on annual profits beyond ₹5 crore at the fund level itself, reducing overall post-tax gains.