Hedge funds, mutual funds and ETFs are all popular pooled investment vehicles in which investors entrust their money to fund managers who in turn invest on their behalf in different kinds of publicly traded securities.
Yet, the fund management strategy in all three of them is entirely different. Let’s see how.
Hedge Fund
A hedge fund is a private portfolio of investments that uses investment and risk management strategies to generate returns. It is a relatively aggressive type of fund that is used by high-net-worth investors. A hedge fund is a pooled investment that is often open to only a limited number of accredited investors. The fund manager then invests the pooled money into different types of assets to generate returns.
Hedge funds are usually set up as limited partnerships or limited liability companies that require a large minimum investment. These are less regulated as compared to mutual funds and ETFs. Hedge funds are very much illiquid as they need investors to keep the investment for at least a year, i.e., they have a lock-in period of one year.
The most important feature is that hedge funds are not subject to the same regulatory requirements as mutual funds. This is an important difference between hedge funds and mutual funds.
Few features that capture the nature of hedge funds can be summarised as follows:
- Hedge funds are unregistered
- They function as private investment partnerships
- They can invest in different markets, strategies
- The underlying instruments can include securities, derivatives and non-securities
- Not subject to the same regulatory requirements as mutual funds
Mutual Funds
A mutual fund also pools funds collected from investors to invest in financial instruments. These funds are controlled and managed by a fund manager on behalf of the investors. The fund manager decides which stock or bond to buy and how much. Mutual funds have to declare their NAVs every day as Sebi regulations govern them.
This is an essential difference between hedge funds and mutual funds. A mutual fund distributes the entire investment amount into small units which are purchased by investors instead of directly investing in stocks and shares themselves. Hence mutual funds are a good starting point for those investors who are not sure of which stocks to pick and how to pick individual stocks.
Since a mutual fund is a collective investment, the risk gets divided among the investors. A small amount of investment in mutual funds can get the investor the benefit of portfolio investment.
There are various types of mutual funds. They can be categorised according to different themes.
Mutual Fund Types Based on Underlying Assets
Equity Funds
The subcategories under equity funds will depend on the type of stocks. There are different types of stocks, depending on the company’s market value: large-cap companies, mid-cap and small-cap companies.
The equity funds will be labelled as large-cap funds depending on the type of stocks it invests in. There are also multi-cap funds which cover all market capitalisations.
Debt Funds
Debt funds invest in bonds of different companies which are mostly categorised according to their maturity tenure. There are short-term, medium-term and long-term bonds. Accordingly, the debt mutual funds that invest in these debt securities derive their names.
Hybrid Mutual Funds
Hybrid funds invest in a mix of equities and debt instruments as per SEBI guidelines.
Mutual funds can also be divided based on investment goals:
- Pension funds
- Fixed maturity funds
- Growth funds
- Income funds
- Liquid funds
- Tax saving funds
For every type of mutual fund, Sebi has laid down strict guidelines for the fund manager and asset management companies (AMC). They have to abide by all the rules and regulations.
Exchange-Traded Funds
An Exchange Traded Fund (ETF) is a marketable security that tracks a commodity, bond or index or basket of assets. ETFs are listed and traded on a securities exchange. It tracks the yield and returns of the financial instrument it follows. ETFs are governed by Sebi and this is also a difference between the hedge fund and ETF.
When an investor invests in ETFs, the money is invested in a bunch of market securities which are a part of a predetermined index. The investment is made in the same proportion of the index.ETFs experience price changes throughout the day.
For instance, the country’s first ETF, Nifty BeES (Nifty Benchmark Exchange Traded Scheme) tracks the S&P CNX Nifty index.
ETFs are considered to be more tax-efficient because frequent trading leads to higher capital gains.
Types of ETFs
Here are a few of the prominent types of ETFs available in India:
Index ETF
Index ETFs invest in stocks of companies in exact proportion as they are in an existing stock market index. By doing this, index ETFs replicate the performance of the index.
International ETF
International ETFs invest in the securities of foreign companies. Multiple international ETFs in India also replicate foreign stock market indices. It is up to the decision of the AMC and the designated fund manager.
Liquid ETF
Liquid ETFs invest in liquid debt instruments. This would mean that the ETFs will invest in short term debt instruments that have a shorter maturity tenure and have higher liquidity. Short term government bonds, money market instruments are a few examples.
Gold ETF
Gold ETFs invest in the bullion market, but you don’t get the actual physical delivery of gold. With Gold ETFs, investors can take benefit from movement in gold prices without having to own the gold physically.
Sectoral ETFs
There might be ETFs which invest in stocks of a particular sector. For example, bank ETFs, will invest in stocks of different listed banks in India.
Hedge Fund Vs ETF Vs Mutual Funds
| Parameter | Hedge Fund | Mutual Fund | ETF |
| Return | Absolute return | Relative return | Relative return |
| Management | Actively managed | Actively managed | Mostly passively managed |
| Fees | Performance-based fee | Percentage of assets managed fees | – |
| Transaction Price | – | NAV | Quoted price on the exchange |
| Transparency | Information disclosed to investors only | Annually published reports and disclosure | Daily disclosure of holdings |
| Regulation | Less regulation | Regulated by SEBI | Regulated by Sebi |
| Liquidity | Low | High | High |
| Cost | – | High average expense ratio | Low average expense ratio |
| Investor Type | High net worth individuals | Retail investors | Retail investors |
| Fractional Shares | No | Yes | No |
| Ownership of Fund Manager | Substantial ownership | Non-substantial ownership | – |
| Owners | Few owners | Many owners | – |
| Minimum amount to be invested | High | Low | Low |
| Tax | – | High percentage of tax levied on capital gains | Comparatively lower tax percentages are levied |
Hope the differences between the three asset classes are clear to you. Whichever asset you choose to make your next investment, do not forget to conduct the necessary due diligence.
Happy Investing!
