When we talk of hedge funds the first image that comes to our minds is that of some 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. Their exclusivity or perceived exclusivity belies their actual function. However, if you are interested in hedge funds, it is vital to understand how they operate from the perspective of an Indian investor. In India, many hedge funds operate as Foreign Portfolio Investors either directly, or they operate as P-Notes of large FPIs.

This is largely different from the mutual funds that most of us invest in for the sake of our long term goals. Let us understand how hedge funds are different from mutual funds? The difference between a hedge fund and a mutual fund is not only about the nature of investors but also the way the funds are managed and the transparency with which they are reported. Let us get a better insight into this hedge fund vs mutual fund debate. Some basics must be addressed first, and these fundamental aspects of both kinds of funds are important to grasp their differences. 

Discussing hedge funds vs mutual funds - some basic concepts

In the simplest of words, a hedge fund refers to a fund comprising a limited partnership which is made up of private investors. The capital of these investors is managed by fund managers who are professionals and who use a variety of strategies to earn above-average investment returns. Hedge fund managers have been known to use tactics like leveraging to earn high returns. Commonly, hedge fund investments are seen as risky and the stakes are high, with minimal investments focused on wealthy clients. Hedge funds may invest in fixed-income instruments, equity and investments that depend on goals which are driven by certain events

When you consider the main difference between a hedge fund and a mutual fund, you will see that mutual funds are largely regulated products of investment. They are open to the public to invest in and are involved in daily trading. Mutual funds are for those retail investors who wish to balance risks and rewards, and although they may pose a risk as they invest in equity in some funds, stakes are not as high as hedge funds. In mutual funds, you get many types, and you can take calculated risks with capital and smaller amounts can be invested. 

Comparing hedge funds and mutual funds..

1.  Let us look first at the nature of these two funds. A mutual fund is a trust which pools the savings of millions of small and medium sized investors and then invests it in equity and debt. The hedge fund is a portfolio of investments in which only a few wealthy and qualified investors are allowed to invest. Normally, the minimum investment required in a hedge fund structure is very high and that keeps most retail investors out of it. The typical investors in hedge funds include pension funds, endowment funds, sovereign funds, family offices and high net worth individuals.

2.  There is a very important difference between a hedge fund and a mutual fund in the way performance is evaluated. Mutual funds are relative performance funds. For example, the returns of a mutual fund are evaluated with reference to the performance of the index or the peer group. If the market has fallen 20% in the last year, then a fund that has fallen by 15% will be considered a good performer.

On the other hand, hedge funds are absolute returns funds. Hedge fund managers are allowed to trade on the long side and the short side. Therefore, they are judged on the absolute returns that they generate irrespective of the performance of benchmark indices.

3.  The way the two funds are managed also differs drastically. For example, mutual funds are managed within very well laid out guidelines and are subject to controls. There are clear restrictions on mutual funds when it comes to allocation to derivatives. For example, mutual funds 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. They can also run a fund for occasional opportunities, 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.

4.  There is a vast difference between a hedge fund vs a mutual fund 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. 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 is why costs in hedge funds can be quite prohibitive, unless the hedge is able to sustain absolute returns year after year.

5.  Lastly, there is the issue of transparency. Hedge fund typically operate as 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. 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 publicly access all this information from the website of the mutual fund.