Difference Between Hedge Funds, Mutual Funds, and ETFs

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 a limited partnership 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 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 is 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 a large-cap fund 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 is 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 an index or a 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 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 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 the benefit of 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, which 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!