Hedge Fund Vs Mutual Fund

I myself had this doubt for quite a long time: What is the difference between a Hedge Fund and a Mutual Fund. This month I started working at D.E. Shaw & Co and during the induction program, I was introduced to the financial concepts. This was different from what I has exposed myself since the last 4 years i.e. algorithms, operating systems, databases, compilers, processors, computation and blablabla.This was a slight shift from my regular track which is computer science, but I really enjoyed a lot. I explored a little more and got a clear understanding of the difference between a Hedge Fund and a Mutual Fund. In this post I would share my findings.

Hedge Fund

A hedge fund is an aggressively managed portfolio that uses leveraging to generate high returns. The word 'hedge' means to minimize or to reduce financial risk. But we see that hedge funds are mostly risky. They are so risky that only big investors invest in hedge funds. They are open to only some specific type of investors specified by regulators. These investors are big institutions such as pension funds and high net worth individuals. The goal of a hedge fund is to maximize returns and do achieve this goal, hedge fund uses leveraging. Now there is a very basic theory in finance which goes as: "Higher the returns, higher the risk involved". Since hedge funds give higher returns, they involve more risk. Then why are they called hedge funds since 'hedging' means to minimize or to reduce risk. Like mutual funds, hedge funds also pool money from investors and then manage them. But hedge funds uses leveraging to maximize gains and that make them risky. Let me explain the concept of hedging by the following example:

Suppose a hedge fund collects 100 $ from investors (I have taken this amount just for illustration. The actual amount that hedge fund invests runs into billions of US dollars). It takes 100 $ from a bank (This is what is leveraging). Now hedge fund has a pool of 200 $ which it invests. Now the bank that lends you 100 $ has a condition: No matter what you gain or loose, I should get 120 $ after say 6 months. Now lets examine 2 cases:

1. Suppose after 6 months, hedge fund makes a profit of 40%. The value of the portfolio is 280 $. Hedge fund gives 120 $ to the bank and distributes 60 $ as profit among investors. Of course, it charges some fees also, but I have not included it in my computations. Hence the investors make a profit of 60%.  Now we see the power of leveraging. Though hedge made a profit of only 40%, it gave 60% profit to investors. This is possible due to leveraging.
2. Suppose after 6 months hedge made a loss of 10%. The value of the portfolio is 180 $.  Hedge fund gives 120 $ to the bank and the value left in the portfolio is 60 $. Of course, it charges some fees also, but I have not included it in my computations. Hence the investors made a loss of 40%.  Now we see the risk of leveraging. Though hedge made a loss of only 10%, it resulted in 40% loss to investors. This is reason why hedge funds are risky.

Mutual Funds

A mutual fund is a type of professionally managed collective investment scheme that pools money from several investors to purchase securities. But unlike hedge funds, mutual funds are highly regulated. Mutual fund is open to common man unlike hedge funds. Due to this reason, mutual funds are highly regulated. They can't invest in any security, but only those which are approved by the regulators. Hence mutual funds are safer than hedge funds. Then again that basic finance theory comes into picture: "Lower the risk, lower the returns". Hence mutual funds don't generate as much returns as hedge funds.

Similarity between a mutual fund and a hedge fund

1. The most important similarity between a hedge fund and a mutual fund is that they both pool money from investors. 
2. One more similarity is that in a hedge fund also investors can withdraw their money as in a mutual fund

Difference between a Mutual fund and a Hedge Fund

In a nut shell, following are the differences between a Hedge Fund and a Mutual Fund:

1. Hedge funds focus on absolute returns while mutual funds focus on relative returns.
2. Hedge funds can invest in any asset class- stocks, bonds, sub prime mortgages, commodities, real estate. While mutual funds can only invest in a set of asset class. Mutual funds have to follow compliance framework set up by the regulator. Hence risky asset classes are debared from  investment.
3. Hedge funds use leverage. Though mutual funds can also borrow to some extent but they are highly regulated.
4. Hedge Fund can run concentrated portfolios. In case of Mutual Funds we have to protect investors' money and hence they always use diverse portfolios.
5. Hedge Funds are meant for richer people to become more rich. Whereas even low worth individuals can invest in a mutual fund.
6. Hedge Funds are unregulated whereas mutual funds are highly regulated.