Hedge Fund vs Mutual Fund

When investors in India look beyond fixed deposits and directly traded stocks, they encounter a world of pooled investment vehicles that are regulated by the Securities and Exchange Board of India (SEBI). The two dominant structures are mutual funds and alternative investment funds (AIFs), which are the regulatory umbrella under which hedge funds operate in India.

While both vehicles pool capital, fundamentally different SEBI rules govern them, they serve distinct client bases, and employ investment strategies with vastly different risk profiles. Understanding these differences is critical for aligning your investment vehicle and knowing more opportunities, while understanding the risk tolerance and financial goals is essential. In this article, we will explore the differences between Hedge Funds and Mutual Funds, their working mechanisms, and how they operate. Keep reading to know more.

What is Hedge Fund?

A hedge fund (often called an AIF in India) is a private investment club for wealthy individuals. It requires a very large minimum investment. The fund manager uses a wider range of strategies than a mutual fund, like borrowing money and trading on the share price to fall (short-selling). Their goal is to make a profit whether the stock market goes up or down. Because they take on more risk and are less regulated, they are not open to the general public. They charge high fees that include a share of the profits.

What is Mutual Fund?

A mutual fund is like a shared investment pot for everyone. It pools money from thousands of ordinary savers and is managed by experienced fund managers. The fund manager diversifies the funds across many asset classes like stocks, bonds, and commodities to reduce overall risk and deliver better returns. They must follow strict rules set by the SEBI, making them highly transparent. You can easily buy and sell units daily, and the fees are generally low compared to other asset classes. Mutual funds are the simplest and most common way for the public to invest for retirement and long-term goals.

Hedge Fund vs Mutual Fund

As we understand the differences, we will compare hedge fund vs mutual fund with the different factors mentioned below:

The Strategy Behind the SEBI Rules

The difference in strategy is not arbitrary; it is a direct consequence of the legal mandate under which each fund operates.

The Power of Leverage and the AIF Mandate

SEBI severely restricts the borrowing or leverage for mutual funds, but it allows mutual funds to borrow limited to 20% of their net assets under management for borrowing purposes only. This is to protect the crores of retail savings in India from the risks of losses.

For Category III AIFs, the ability to use leverage is a cornerstone of their operations. As per SEBI, the May 07, 2024 Circular, it allows AIFs Category 3 to keep up to 2 times leverage. The managers can deploy strategies like Equity Market Neutral, where a manager seeks to profit from the minor difference between two related stocks. 

For example, a fund manager can go long on HDFC Bank and short ICICI Bank, interpreting it as ICICI Bank being overvalued compared to HDFC Bank based on historical valuations, and the fund manager expects both stocks to revert to their mean. The trade is risky, as it can go either way as well. Since the returns on these trades are often small, high leverage is necessary to generate meaningful overall portfolio returns. This freedom to leverage is the AIF’s core advantage, which is usually reserved for the HNI class. 

Skill-Based Returns

In India, short-selling is primarily executed by AIFs in the Futures and Options (F&O) segment to achieve directional bets or, more commonly, to create a market-neutral strategy.

A long/short equity AIF will simultaneously buy undervalued stocks or go long and sell overvalued stocks, or short. The goal is to eliminate the market's risk, which is beta, and ensure that the returns are solely a function of the manager’s stock-picking skill, or alpha. This ability to profit when the market falls or simply stays flat is the nature of the absolute return goal that AIFs chase. This relates to earning outperformance in every market, up and down. 

Illiquidity for Strategy Protection

The Rs 1 Crore minimum and lock-in periods mandated by AIFs serve a practical purpose, as they ensure capital stability. Many profitable AIF strategies, especially those involving complex derivatives or private investments in public equity (PIPEs), require managers to hold positions for specific timeframes. The lock-up periods prevent a rapid fund outflow by investors, which would force the manager to liquidate complex positions prematurely at a loss, thus protecting the strategy and the remaining investors' capital.

The Reality of Performance: Hedge Fund vs Mutual Fund

The high fee structure of AIFs creates an expectation of guaranteed high returns, but investors must look through the lens of risk-adjusted performance.

The Decline in Average Alpha vs. The Index

Multiple sources often showcase that the hedge funds have sometimes lagged behind a low-cost Nifty 50 Index Mutual Fund over long-term bull market periods in India.

This challenge arises from two factors:

• High-Cost Hurdle: The 2% management fee and 20% profit share create a massive performance target. A fund must consistently achieve spectacular gross returns just to match the low-cost market-tracking mutual fund.

• Market Efficiency: The Indian markets are rapidly becoming more efficient, making genuine, repeatable Alpha harder to find, putting pressure on all high-fee active managers.

Risk-Adjusted Performance

The true value of an AIF is not its return during a market rally but its ability to protect capital during a crash. The performance must be judged on risk-adjusted returns.

• The Bear Market Test: When the Sensex or Nifty drops by 30%, a traditional mutual fund will inevitably drop close to that level (depending on the correlation between the index and that particular mutual fund). However, a well-managed AIF that employs market-neutral or short-selling strategies may manage to stay flat or generate a small positive return. This ability to provide non-correlated returns is the core reason HNIs pay premium fees for AIFs.

• The Investor Mandate: HNIs and institutional investors use AIFs specifically for this diversification and capital preservation mandate, seeking returns that are independent of the broader market's directional movement.

The AIF with Survivorship Bias

Investing in an AIF is fundamentally an investment in a manager’s skill, not an asset class. The AIF industry is susceptible to survivorship bias; only the successful funds that report stellar returns continue to operate, while hundreds of underperforming funds liquidate quietly. This underscores the need for HNIs to conduct deep, professional due diligence on the fund manager before committing capital.

Conclusion

As we near the conclusion of the article, we understood how both types of funds work. For the average Indian investor seeking stable, long-term wealth accumulation, the highly regulated and low-cost mutual fund remains the most appropriate and secure vehicle.

For the high-net-worth individual who meets the Rs 1 Crore minimum and requires specialised, non-correlated returns for complex portfolio management, the Category III AIF offers the sophisticated tools necessary.

Many investors first check a company’s market capitalisation and then evaluate the regulatory structure of the fund they are considering. You might compare the regulated, lower-cost options suitable for core wealth with more flexible, higher-cost structures like AIFs, depending on your financial capacity and risk tolerance. It’s best to seek guidance from a qualified financial professional to understand what fits your profile. If you are exploring mutual fund options, platforms like Rupeezy provide a convenient and secure way to start investing.

FAQs:

Q1) What is the minimum investment required for a hedge fund compared to a mutual fund?

A hedge fund requires a minimum of Rs 1 crore, while mutual funds can be started with as low as Rs 100 or Rs 500 via SIPs.

Q2) Who can generally invest in a hedge fund?

Hedge funds are restricted to high-net-worth individuals (HNIs) and institutions, not the general public.

Q3) What is the key difference in the investment strategy between the two?

Mutual funds typically follow long-only, diversified strategies, whereas hedge funds employ more aggressive tactics, such as leverage and short-selling.

Q4) Which type of fund is generally more transparent and highly regulated by SEBI?

Mutual Funds are highly regulated by SEBI and offer high transparency with daily NAV and portfolio disclosures.

Q5) What is the primary goal of a hedge fund strategy, unlike a mutual fund?

A hedge fund's goal is absolute return, which is to make money regardless of market direction, while a mutual fund aims for a relative return, especially to beat a benchmark.