Hedge Funds vs. Mutual Funds
Hedge funds are both exclusive as well as elusive. They differ from other funds like mutual funds in a large number of ways. In this article, we have listed down the differences between a hedge fund and a mutual fund.
Funds like mutual funds are available to every investor. There is no regulation that prohibits anyone of legal age from investing in a mutual fund. However, that is not the case with hedge funds.
Hedge funds are considered extremely risky and most regulators across the world believe that individual investors neither have the sophistication nor the risk appetite to invest in such funds. It is for this reason that only high net worth individuals are allowed to make investments in these funds. In the United States, they are called accredited investors and their definition keeps on changing from year to year to reflect the inflation in the economy.
A mutual fund typically consists of thousands of investors. Each investor can invest a very small amount lets say $10 and the fund would allow that. Since the ticket size is so small, mutual funds have hundreds of thousands if not millions of investors. Mutual funds are not allowed by law to set up a minimum ticket size.
However, there is no such regulation when it comes to hedge funds. They are private investment companies that are not registered. Hence, hedge funds may have a huge ticket size, lets say $50000. This allows to them to ensure that their investors have the required risk appetite. Also, a typical hedge fund is composed of not more than 500 investors. The idea behind keeping the number of members so low is that secrecy can be easily maintained when there are fewer individuals in the group and each individual has a huge stake.
A mutual fund is therefore like a public garden wherein everyone can visit whereas hedge funds can be compared to an exclusive members-only club.
Mutual funds are closely regulated entities. The amount of risk that they can take is defined by law. Since mutual funds are in possession of retirement savings of millions of people, the government oversees their functioning to ensure that they do not undertake any sort of speculative investments. However, critics believe that the government also filters out some of the best investment opportunities with its high handed regulation.
Hedge funds have no legal rules preventing them from undertaking leverage. In theory, a hedge fund could undertake a 100:1 leverage and in practice many of them actually do. A leverage ratio of 6:1 is the norm in the industry. In fact, an extremely high level of leverage is what characterizes the hedge fund industry. It is almost like a defining feature.
Mutual funds can only invest in certain asset classes. Once again since the government feels that mutual funds are playing with public money, it interferes with regards to when and how this money can be used. Anything remotely speculative, for instance, structured finance and derivatives, is straight away outlawed. Also, when mutual funds are chartered, they are expected to provide a list of the asset classes that they will use as well as the investment strategies that they will use. Deviation from these statements can cause significant regulatory troubles and may cause grave consequences for the mutual fund.
Hedge funds, on the other hand have no such compulsion. They are free to choose the asset the like. They can invest and lose as much money as they want. Also, they can change their investment strategies within a minutes notice. There is no approval required from investors to make such changes. As long as the management of the hedge fund feels that a particular investment strategy is good, they are free to make their choices and also suffer the consequences!
Every aspect of mutual funds business is regulated. The people working for these funds, the services they employ as well as the finances they raise. Everything needs to be made available to the investing public. Also, the net asset value of the mutual funds must be made available every single day. Therefore, the net worth of the portfolio held by the fund is public knowledge. Also, investors are allowed to enter and exit the fund on a daily basis.
Hedge funds are not bound by law to make any such disclosures. Their financial statements need to be prepared monthly or quarterly. Also, investors can exit and enter the fund only during this time. Hedge funds are not subject to excessive scrutiny like the mutual funds.
Mutual funds may have an active secondary market. This means that customers could sell their units to other customers and liquidate their money without the fund actually having to pay back. This is not the case with hedge funds. Since these funds are exclusive, the units need to be sold back to the fund itself. There is no active secondary market wherein hedge fund investments can be sold to other buyers.
There is no difference in the taxation between mutual funds and hedge funds. In both cases, the income generated is not taxed at the fund level. This income is paid out to the investors in the form of dividends. Once the money is in the hands of the individual, it is taxed as per his/her income rate. However, hedge fund managers have a variety of techniques that allow them to make the returns more tax efficient for their clients. Mutual funds usually do not undertake such strategies because very few of their clients actually fall in higher tax brackets.
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