What is a Hedge fund ? How is it different from Mutual fund?

We have often heard of mutual funds and seen advertisements about them but we rarely hear of hedge funds. Hedge funds are also pooled investments by investors and are managed by hedge fund managers just like Mutual funds. All they have are different characteristics and principles.

The word "hedging" in the world of finance means "to protect or shield from potential losses of capital or in other words to limit risks". This is achieved in financial markets by taking opposite positions with your primary positions. This put a limit both to your gains and losses. For example, if you invest Rs. 1 lakh in a stock then you have potential to lose 100% money if the company goes bankrupt but with the help of hedging techniques, you can limit your losses to say 10% or less by taking short positions (i.e. you make money if stock falls). Derivatives are used for this purpose. This is the main purpose of hedge funds. Though, hedge funds today are much more than this. Let's understand in detail.

We can broadly say that there are two types of people that plays in markets, Investors and Traders. Investors earn returns if the market grows (we call it long position) and traders earn returns if the market fluctuates i.e. even if market falls they earn returns (both long and short position). Mutual funds are aligned to investor mindset and Hedge funds are aligned to a mix of investor and trader mindset. Many hedge funds got popular during the 2000 Tech bubble and during 20008 financial crisis as they earned big sum of money by speculating the fall of market correctly. It is very difficult to earn money from taking long/short positions but those who know well how to earn returns, make it big. In simple words, when 99% people lose money in the markets, the other 1% gets to keep all this money. Hence, hedge funds are risky investments but can generate huge returns.

As hedge funds are risky investments, they are not open for general public investors like you and me. You need to be a accredited investor to be eligible to invest in hedge fund. SEBI defines the accredited investor as "the one who has total gross income of 50 lakh annually and one who has at least liquid net worth of 5 crores." In simple words, you need to be rich to be eligible to invest in hedge funds. The bright side is that Hedge funds are not regulated by government (SEBI to be precise) but Mutual funds are regulated. People like you and me are a bit protected as SEBI keeps check on these mutual funds whereas hedge funds have the freedom or are unregulated and government has no issue if rich lose their money or in other words, the rich can absorb the loss. The question is that does regulation make a difference? and the answer to it is that it makes a hell lot of difference. Mutual funds need to work according to guidelines of SEBI, they are restricted with risky investments and sometimes with some rules set by SEBI. Following is a recent change brought by SEBI on multi-cap funds. Hedge funds are more of private investments and can keep secrets away from people like you and me. For example, It is speculated that Jim Simons, a mathematician and owner of hedge fund Renaissance Technologies has given higher returns to investors than the legend Warren Buffet. We don't know the truth and Warren Buffet is No.1 for us.

Mutual funds charge 1-2% as expense ratio (fees for managing your capital) on your invested capital. Hedge funds charge 2-4% as expense ratio as well as they take 20-30% share of profits earned on the invested capital. Though mutual funds give returns in the range of 5-15% annually whereas the hedge funds have capability to give returns in the range of -30% to 60% annually. Hedge funds can short the stocks/bonds which mutual funds cannot. Hedge funds also help their clients (business owners) from risk of price fluctuations in commodities and forex markets. Hedge funds can invest in stocks/bonds, gold and other commodities, real estate, startups etc. In simple words, their goal is to make higher returns than any other funds. Some of the largest hedge funds in the world are Renaissance Technologies, Two Sigma, AQR Capital, Bridgewater Associates, Elliott Management Corporation, D.E. Shaw. Some of the noted hedge fund managers in the world are George Soros, Ray Dalio, Bill Ackman.

Thank You.

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