Mutual funds have become a household name, particularly the Systematic Investment Plan.
Within mutual funds, individual investors are mainly investing in a variety of equity-oriented schemes, looking to earn better returns than some traditional avenues.
But having tasted success, of late, investors are also curious to know about hedge funds and know the difference between them and mutual funds.
So, in this editorial, we explain the key difference between hedge funds and mutual funds and tell you which one is better suited for your investment needs.
Mutual Funds
A mutual fund scheme, as you may be aware, pools money from multiple investors and invests the collected corpus in various securities, such as stocks and fixed-income instruments, depending on the investment mandate of the scheme.
For every type of scheme – equity, debt, hybrid, solution-oriented, index funds, ETFs – and their subtypes, the capital market regulator has defined their investment characteristics or mandate.
So, the asset allocation needs to be done accordingly. For example, a large cap fund is mandated to invest a minimum of 80% investment in equity & equity-related instruments of largecap companies.
There are a total of 11 such sub-categories with a unique investment mandate.
Similarly, in the case of debt funds, where there are 16 sub-categories, they are defined by the regulator based on the maturity and other characteristics.
In case of hybrid funds, depending on how much is allocated to equity, debt & money market instruments, six sub-categories exist.
Other than the above three broad categories of mutual funds – equity, debt, and hybrid – you have solution-oriented funds addressing your child’s future needs and your retirement.
There are also index funds, ETFs (which are passively managed) and fund of funds.
Who Invests in Mutual Funds?
Typically, it is the retail and HNI investors deploying their hard-earned money into mutual funds.
The minimum investment can be as low as Rs 500, and this is why the base of mutual fund investors is large.
Hedge Funds
Hedge funds are private investment pools that employ various strategies to earn active returns.
The popular strategies hedge funds follow are…
Long and short – This involves taking both long and short positions in stocks with the objective to minimise the market risk and potentially profiting from both rising and falling stock prices.
Short selling – This involves taking short positions when the market looks bearish and benefiting by covering up the shorts when the market begins to ascend.
Leverage and derivatives – The fund manager leverages the positions using derivative strategies for hedging or non-hedging purposes.
Arbitrage – This involves exploiting price differences (called spreads) between the cash and futures segments of the equity market. So, the equity positions are fully hedged.
Convertible Arbitrage – Involves buying convertible bonds and simultaneously short-selling the underlying stock, taking advantage of price discrepancies between the two.
Event-based – A hedge fund manager takes advantage of a corporate event, such as mergers & acquisitions, demerger, spin-off, or any such event that could significantly impact the stock price of the company.
Global Macro Trends – A hedge fund manager attempts to profit from macroeconomic trends related to politics, economic cycle, interest rate cycle, etc., to generate returns.
Distressed Securities – This involves investing in distressed or bankrupt companies, hoping to turn them around and generate profits.
Fixed Income – The hedge fund manager trades in various fixed-income instruments, such as government securities, corporate bonds, and/or mortgage-backed securities.
These strategies are designed to generate relatively higher returns compared to the market and involve high risk.
Who Invests in Hedge Funds?
Usually, hedge funds pool the money from affluent investors (Ultra High Net Worth Individuals) and institutional investors.
As per SEBI regulations, hedge funds fall under the Alternative Investment Funds (AIFs) – Category III.
The minimum investment required from each investor is Rs 10 million.
Regulations for Mutual Funds and Hedge Funds
Both mutual funds and hedge funds are regulated by the Securities and Exchange Board of India (SEBI).
For mutual funds, the SEBI (Mutual Fund) Regulation 1996 applies, which is strict and ensures timely scrutiny and accountability. In the last two decades, the regulator has taken various measures prioritising interest first, including mandatory disclosures by fund houses.
Hedge funds, on the other hand, are regulated under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.
As hedge funds in India (under Category III AIF) are in the nascent stage compared to global markets, currently, they are not very tightly regulated.
Moreover, the transparency relating to disclosures and portfolio strategies is low compared to mutual funds.
Fund Management Fees for Mutual Funds and Hedge Funds
Mutual Fund expense ratio (which includes management fees, marketing expenses, and operational costs) ranges between 0.8% and 2.25% of its daily assets, depending on the type of scheme (equity, debt, other) and its AUM.
Hedge funds typically charge around 2% fund management fees as a percentage of their assets, as well as a performance fee, which is a percentage of profits earned by the fund.
Taxation of Mutual Funds and Hedge Funds
Depending on whether a mutual fund scheme is equity-oriented or debt-oriented, capital gain tax applies.
Equity fund realised gains under one year are taxed at 15% Short Term Capital Gain Tax (STCG). After one year, realised long-term gains above Rs 1.25 lakh in a financial year attract 12.5% tax.
As far as debt mutual funds are concerned, they are taxed as per your income tax slab.
[Read: All You Need to Know About Capital Gain Tax on Your Mutual Funds]
Hedge Funds that are 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 you at a disadvantage.
Conclusion: Which is Better?
Investing in mutual funds has certain advantages over hedge funds, as seen above.
Mutual funds are suitable for retail and HNI (even UHNI) investors aiming for steady growth of capital over a period without taking undue risks.
Hedge funds, on the other hand, are more suited for seasoned and institutional investors who have a substantial investment corpus and a high-risk appetite.
Invest thoughtfully considering your risk profile, investment objective, financial goals, and the time in hand to achieve those goals.
Happy investing.
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