Hedge Fund vs Mutual Fund: Two Different Contracts

Nilgiri Absolute Return Fund, invented, is a private fund paid into in full on the day rather than promised money and called on later. The fund deals on its own contracted arrangement rather than on demand, and the manager's share of any gain is charged only above a level it has already charged at. A listed pooled vehicle differs from it in five places, and every one of the five is a term of a contract rather than a matter of what either manager buys.

A comparison usually means two things drawn at the same size, side by side, with the differences ticked off in the middle. The two structures here do not sit that way. One of them writes every term into a document an investor signs, so it can be described from the inside, term by term, on an invented fund whose numbers are fixed. The other is settled by a regulator whose conditions change, so the honest answer on that side is one sentence and the name of the source.

Both of these things are pooled vehicles run by somebody else. Many people put money in, one manager decides what to do with it, and each person holds a slice of the whole rather than any particular thing inside it. The overlap ends there. Everything after it is a difference of contract rather than a difference of style: what the investor holds, when the investor may leave, what the manager may do, what the manager has to achieve before it is paid a share of anything, and what gets published to whom. Every one of those is written down and signed before a rupee moves.

What are the two things being compared, and what do they actually share?

Consider two ways of putting money into a neighbourhood venture. In the first, an investor walks up to a counter, hands over the money, and gets a printed receipt saying how many shares of the whole the investor now holds. Anybody can walk up to that counter, and anybody holding a receipt can walk back and hand it in. In the second, somebody sits across a table from the investor with a folder, the investor reads the folder, and then both sign it. The folder says when the slice may be handed back, what happens if too many people ask at once, how much the organiser is paid, and what has to happen before the organiser is paid a share of the profit. The first arrangement is governed by a counter and a published price; the second is governed by a document the investor agreed to.

The counter and the folder are the whole comparison in one sentence, and everything below reads the folder. The invented fund it uses is Nilgiri Absolute Return Fund, run by Nilgiri Alternatives Advisors Private Limited, invented, with Nilgiri Trusteeship Services Private Limited as trustee and Nilgiri Financial Holdings Private Limited as sponsor. The fund is an open-ended vehicleOne that takes new money and pays money out on a continuing basis., meaning it takes new money and pays money out on a continuing basis rather than raising a fixed pot once and shutting the door. The fund is registered in India as a Category III Alternative Investment Fund. What any category requires is set by the Securities and Exchange Board of India at sebi.gov.in and read there.

One word about the label in the title. "Hedge fund" names an approach to investing rather than a legal form, and what this invented fund actually does with the money it holds is covered separately. The label turns out not to matter at all for the comparison, and seeing why is the first real idea here. Everything that separates these two structures is in the contract and the registration, not in what either manager happens to buy. The difference lives in who may put money in, how it comes out, how the manager is paid and what is published, so two managers could hold exactly the same things and still be running two completely different vehicles.

What is an investor actually buying in each case?

In both cases the investor is buying a slice of a pool, and in both cases the slice is called a unitOne share of an open-ended vehicle, valued by dividing net assets by the number in issue.. The word is genuinely the same word for genuinely the same idea, and it is the last thing about these two structures that is. The act that produces the unit differs, and the act is where the structure lives.

On the private side the act is a subscriptionMoney paid into an open-ended vehicle in exchange for units, in full, at once.. The investor signs, pays the whole amount, and units are issued. Nilgiri Absolute Return Fund, invented, issued 5,00,00,000 units at Rs 100.00 each at its launch, raising Rs 5,00,00,00,000 of money that was actually in the fund's bank account rather than promised to it. There is no commitment and no capital call anywhere in this vehicle, and that single structural absence is the cleanest way there is to see what a commitment actually is.

The everyday version runs like this. A season ticket for a year of local bus travel is a subscription: the whole fare is paid today, the pass is handed over today, and nobody rings in month seven asking for more. Booking a wedding hall two years ahead is a commitment: the whole booking is signed for, a small part is paid now, and the rest is asked for in instalments as the dates approach. The total is the same number in both stories. The two stories differ in when the money leaves the buyer's hands and in who decides that timing. In the second story the buyer does not decide it.

The closed-end private funds in this subject area work the second way. In Nilgiri Growth Partners Fund II, invented, investors promised Rs 5,00,00,00,000 and the manager had called Rs 4,80,00,00,000 of it by the end of the fund's own Year 9 Quarter 2, being 96.0 per cent of what was promised, leaving Rs 20,00,00,000 promised and not yet asked for. An investor in that fund has to keep money available for a call that has not arrived yet. The money went in whole, on the day, so there is nothing left to call. An investor in the open-ended fund described here carries no such obligation at all.

The listed side answers this question in one sentence: a unit in a listed pooled vehicle is bought and sold at a price somebody publishes, and how that vehicle works internally is covered separately and is not re-taught here.

Two later questions depend on one more thing sitting inside the word unit, so it is worth pulling out first. A unit is a share of the whole, not a claim on anything in particular. If the fund holds forty different things, the holder does not hold a fortieth of each of them in any way that could be collected. The holder holds a fraction of net assetsWhat the vehicle holds less what it owes, at a stated date., meaning what the vehicle holds less what it owes, measured at a stated date. Every question about getting money out is therefore really a question about the fund selling something, and never about the fund handing over a share of what it holds.

How does an investor get the money out, and when?

Consider the shared van that runs from a neighbourhood to the district town. The van leaves at four fixed times a day, the driver has to be told the evening before, and if fifteen people want the eight seats then eight people travel and the rest are put on the next run. Nobody in that story is being unreasonable and nobody is stopped from travelling. The van simply runs on a timetable that was agreed before anybody started using it, and the timetable is the whole of what makes it different from stepping into a rickshaw at the corner. Getting money out of a private open-ended fund works like the van, and the timetable is a contract the investor signed.

The act itself has a name. A redemptionThe vehicle buying an investor's units back out of its own assets. is the fund buying an investor's units back out of its own assets. Selling those units to somebody else is a different event altogether. The distinction is doing more work than it looks. When the fund buys the units back, the money has to come from what the fund holds, so somewhere behind the request either cash is already sitting there or something has to be sold to produce it. Nobody else has stepped in to take the investor's place. The pool got smaller by exactly the amount taken out.

Because of that, Nilgiri Absolute Return Fund, invented, contracts for four separate terms that stand between a request and a payment. Each takes one sentence. The first is a lock-upA contracted period after subscription during which no redemption is accepted. of twelve months from each subscription, during which no redemption is accepted. The second is a redemption window: quarterly dealing on the last business day of each quarter, with 45 days' written notice, payment within 30 days of the dealing date, and a holdback of 10.0 per cent of the redemption amount released after the annual audit. The third is a gate: no more than 20.0 per cent of any one investor's holding and no more than 25.0 per cent of the fund's net assets may be redeemed at a single dealing date, with the excess scaled back pro rata and carried to the next window. The fourth is a side pocket: a holding the manager designates as not reliably valuable may be moved into a separate class in which no subscription or redemption is accepted until it is realised.

Every one of those four numbers is this invented fund's own contracted term and nothing else, and none of them is standard, usual or required of anybody. A different private fund could contract for something completely different, and what a regulator has to say about any of it is set by the Securities and Exchange Board of India at sebi.gov.in and read there. How these four terms interact with each other, and in what order they bite when a request runs into more than one of them at once, is covered separately and is deliberately not worked here.

The listed side answers this question in one sentence: it is dealt at a published price, on conditions set by the Securities and Exchange Board of India at sebi.gov.in.

Notice what the four terms have in common, because it is the reason they exist rather than a quirk of drafting. Every one of them protects the fund's ability to pay the people who stay from the actions of the people who leave. If everybody could ask for everything on any morning, the manager would be forced to sell whatever could be sold fastest, and the investors who did not ask would be left holding whatever was left. The contract is doing the job that a queue of ready buyers does elsewhere, and it does that job by slowing the queue down rather than by finding more buyers. The cost of that trade-off to the person on the inside is the central subject of a separate treatment.

How is the manager paid, and what has to happen first?

The way a manager is paid is where the real teaching sits, and it repays slow reading. Two charges are written into the documents of Nilgiri Absolute Return Fund, invented, and a reader who treats them as two numbers on the same shelf has missed the only thing worth understanding about them. The two charges are not two rates of the same instrument. One is charged on a base and the other is charged on a result, and that difference is structural rather than a matter of size.

Take the everyday version first. The story below is exact rather than merely illustrative. The security guard at a building is paid every month. He was hired to stand at the gate, and that is what he did, so he is paid in a year when the building's value rises, in a year when it falls, and in a year when nothing at all happens to it. The property agent who eventually sells a flat in that building is paid differently: nothing at all unless a sale happens, and then a share of it. Now add the sharpest bit. Imagine the agent's contract says he is paid a share only when the sale price beats the highest price the building has ever fetched, not the last one. In a year when a flat sells for more than last year but less than the record, he does the work, the sale happens, the seller is better off, and the agent is paid nothing. Nobody has been cheated in that story, and the contract has done exactly what it says.

The charge on a base

The management fee of Nilgiri Absolute Return Fund, invented, is 2.00 per cent a year, charged on net assets. On the Rs 5,00,00,00,000 of net assets this invented fund reports at the record date, 2.00 per cent a year is Rs 10,00,00,000 a year. The base is what the fund holds rather than anything the fund achieved, so the fee is charged whether the unit rises, stands still or falls.

Why net assets, and not something else? Because in this vehicle there is nothing else. The closed-end funds in this subject area charge a fee on the money investors promised, and then, once the investing period ends, on the cost of what they still hold. An open-ended fund has no promises outstanding and no capital call to make, so the only base available to it is what it holds today. The fee base is not a preference the manager expressed; it is the only thing this structure leaves to charge on. The habit is worth carrying: when a fee looks odd, ask what the structure left available as a base before assuming somebody chose it.

The charge on a result

The second charge is a performance feeA share of gains, taken only above the mark. of 20.0 per cent, charged annually, and it exists only if something has already happened. The something is a rise above a high-water markThe highest unit value on which a performance fee has already been charged., meaning the highest unit value this fund has already charged a share of gains on. Below that level there is no charge at all. At that level it is nil. Above it, only the part above is charged, and the rest of the unit's value is never charged twice.

Read those two charges as instruments rather than as percentages and the comparison the title promises becomes easy to make without ranking anything. One is an obligation of the fund that arises with the passing of time. The other is a contingent claim that arises only if a defined event occurs, and in a year when the event does not occur it is worth nothing at all to the manager. A charge that is contingent on a result and a charge that is not are different kinds of thing, and calling them both fees is the beginning of most of the confusion about them. The fee arrangement for the listed side is set out in that vehicle's own documents and governed by the Securities and Exchange Board of India at sebi.gov.in.

What has to happen before a share of the gain is charged at all?

Now the worked case, and it is a small one. Nilgiri Absolute Return Fund, invented, has a five-year record of unit values, and two of its years appear here: its Year 2 and its Year 3. The full five-year table is covered separately, and saying which two years appear is part of reading them honestly.

At the close of this fund's Year 2 the unit stood at Rs 99.00. At the close of its Year 3 the unit stood at Rs 106.00. The unit rose Rs 7.00 across Nilgiri Absolute Return Fund's own Year 3, being 7.07 per cent on the Rs 99.00 the unit started that year at. The mark in force across both of those years was Rs 110.00, being the highest unit value this fund had already charged a share of gains on. The share of the gain charged for this invented fund's Year 2 was Rs 0.00 a unit, and the share charged for its Year 3 was also Rs 0.00 a unit, even though the unit rose 7.07 per cent across Nilgiri Absolute Return Fund's own Year 3.

The second figure is the whole reason this fund appears at all, so it repays a moment. A year passed. The unit went up. Every investor holding it at the start of that year was better off at the end of it. And Rs 106.00 is still Rs 4.00 below Rs 110.00, so the manager received not one paisa of the share of gains. Nothing has gone wrong. The mark exists to stop a manager being paid twice on the same rupee of value. The ground between Rs 99.00 and Rs 110.00 had already been charged on once, back when the unit first reached Rs 110.00, and it is not charged on again on the way back up.

The next step is arithmetic and nothing more, and it is worth stating precisely. From the Rs 106.00 at the close of Nilgiri Absolute Return Fund's own Year 3, the unit would have to reach Rs 110.00 before a single rupee of the gain share arose. The climb is a further Rs 4.00, being 3.77 per cent of it. Only the part above Rs 110.00 would then be charged, at 20.0 per cent of it. Nobody knows whether the unit reaches Rs 110.00, or when, and a mark records only which rupees of value have already been charged on rather than anything about the ones that follow.

A reader who has just understood the mark often jumps to a second reading of that year, so the second reading is worth naming. The mark is not a promise about the future and it is not a measure of skill. The mark is a rule about which rupees of value have already been charged on. The mark says nothing at all about what the fund holds, what it will do next, or whether anybody should be anywhere near it. A fund can sit below its mark for a long time or pass it in a quarter, and this record does not say which happened next.

What does the price of one unit mean when it is struck rather than traded?

Two numbers can both be called the price of a unit and be completely different kinds of number. One of them is a record of something that happened: somebody offered, somebody accepted, and the figure is what changed hands. The other is a calculation somebody performed on a stated date: take what the vehicle holds, take away what it owes, and divide by how many units are in issue. The first kind of price is evidence of an event; the second kind is an arithmetic, and an arithmetic is only ever as good as the inputs somebody put into it.

The private open-ended fund described here produces the second kind. Somebody has to do it, on a date the documents fix, using values for the things the fund holds. In the closed-end fund run by the same invented manager, Nilgiri Growth Partners Fund II, that job sits with Kolar Fund Services Private Limited, invented, as administrator, and with Ashwin Baliga, invented, the fund controller who strikes the figure. The independent valuation agent is Palani Valuation Advisors LLP, an invented limited liability partnership (LLP). A private mark, how it is made and how it differs from a struck total for a whole vehicle are all covered separately. The structural point is only this: a struck price has an author and a date, and both of them are named in the documents.

Now a refusal, and it is a good one to copy. The record for this invented fund fixes 5,00,00,000 units issued at Rs 100.00 at launch, being Rs 5,00,00,00,000, and net assets of Rs 5,00,00,00,000 at the record date. The one number the record does not fix is how many units are in issue at that record date, and in an open-ended vehicle that number moves every time somebody subscribes or redeems. The two numbers are not from the same date, so the second figure is not divided by the first. The division would produce a unit value nobody's record supports. A reader who spots two numbers that could be divided, and asks first whether they belong to the same moment, has learned the most transferable thing in this guide.

The listed side answers this question in one sentence: it has a published price, and how a published price is arrived at is covered separately.

What may the manager hold, and what gets published to whom?

The two questions look like they belong to different parts of the document, and structurally they are the same question asked twice: who set the limit, and who is the audience. Take them together.

A private fund's holdings and its conduct are fixed in two places. The first is its own constitutional documents, the trust deed and the contribution agreement that every investor signed. The two documents say what the vehicle was set up to do and what it may not do. The second place is its registration, and the category a vehicle is registered in carries conditions attached to it. The conditions attaching to any category are set by the Securities and Exchange Board of India at sebi.gov.in, they change, and they are read there for either side of this comparison. Nilgiri Absolute Return Fund, invented, is registered in Category III, and the conditions that category carries are set at that same source. The things this fund actually buys with the money it holds are covered separately.

Publication, and the audience it goes to, works the same way. A private fund reports to the people who signed its contract, on the timetable that contract sets, and that is a small and named audience. The record for this invented open-ended fund does not fix what it sends its investors or how often, and no general rule supplies the answer either, because the reporting timetable of a private fund is whatever its own contract says. The listed side answers this question in one sentence: what a listed pooled vehicle publishes, to whom, and how often is set by the Securities and Exchange Board of India at sebi.gov.in.

The pattern has now appeared three times. Where a question is answered by a contract, it can be answered completely. The contract is written down, and the invented fund's version of it is fixed. Where a question is answered by a regulator, the regulator is named and the answer stops there. The line between the two is not a matter of how much research anybody did; it is the difference between a document that says what it says and a body of conditions that changes.

Who can put money in, and does that change the structure?

Who may put money in is the question readers arrive with most often, and it is worth being exact about why so little can be said in answer to it. Who may be admitted to a pooled vehicle is settled by the conditions attaching to its registration, and those conditions are set by the Securities and Exchange Board of India at sebi.gov.in, they change, and the current text is read there. No minimum, no eligibility test and no investor condition holds for either the private vehicle or the listed one outside that source. A number of that kind feels like knowledge, so carrying it in the head after the source has moved is worse than having no number at all.

The structural answer can be given in full, and it is more useful than the number anyway. Who is allowed in is a registration question, and it does not change one line of the machinery described here. The subscription is still paid in full on the day. The lock-up, the window, the gate and the side pocket still say exactly what they say. The 2.00 per cent is still charged on net assets and the 20.0 per cent still arises only above the mark. A vehicle admitting a hundred investors and a vehicle admitting twelve run on the same contract if the contract is the same contract.

Think of a co-operative housing society. The rules about who may be sold a flat and the rules about how the society is run are two different documents, and changing the first does not renumber the second. A new resident inherits the same maintenance schedule, the same parking allotment and the same rule about the terrace. Structure and admission are separate questions, and the habit of keeping them separate is what stops a reader concluding that a vehicle open to fewer people must therefore work differently on the inside.

If somebody handed a reader these documents for an hour, what would be worth reading for?

Far more people read a private fund's documents than ever put money into one, so reading them well is worth taking seriously. Analysts read them to reconcile somebody else's reporting. Operations teams read them to work out when money can be relied on. Students read them because the terms are where the subject actually lives. Four reading moves follow, in the order that wastes the least time, and every one of them comes from a question already worked through above.

First, find the act rather than the label. One sentence in the document says whether money goes in as a payment or as a promise, and everything downstream follows from it. If the money is subscribed, the investor's obligation ends on the day. If it is committed, the investor carries an obligation for years and has to keep the money available for a call that has not arrived. Nilgiri Growth Partners Fund II, invented, still had Rs 20,00,00,000 of the Rs 5,00,00,00,000 promised to it uncalled at the end of its own Year 9 Quarter 2, and every investor in it has to plan around that. The open-ended fund described here leaves nobody carrying anything of the kind.

Second, read the exit terms before reading anything about how the manager invests. Count how many separate terms can stop or reduce a request. In Nilgiri Absolute Return Fund, invented, the count is four, and each of them is a different test: a period, a calendar, a proportion, and a designation the manager makes about a particular holding. An operations team planning an institution's cash across the next four quarters cannot treat money inside a vehicle like that as available on a date of its choosing, and the reason is not the manager's attitude. The reason is the document, and everybody signed it.

Third, read the fee as two instruments and find the base of one and the trigger of the other. For the charge on a base, find the base. In this fund the base is net assets, and an open-ended vehicle leaves nothing else to charge on. For the charge on a result, find the point the mark is measured from. If it is measured from the start of the year, a fund that fell and recovered pays twice on the same rupees. If it is measured from the highest value already charged on, it does not. The mark is exactly where a reader reconciling somebody's numbers gets a surprise and calls it an error: a year with a rise and a nil charge is the mark working, not a mistake in the accounts.

Fourth, read what is not in the document at all. The four terms above are contract; the conditions attaching to the vehicle's registration are not. Anything of that kind is set by the Securities and Exchange Board of India at sebi.gov.in and read there, at the date of reading. The household version of that move is a familiar one: when somebody signs for a recurring commitment, the schedule of what is owed and when is in the paper in front of them, and the rules about who may offer that arrangement at all are somewhere else entirely. Reading the first and assuming the second is how people end up confidently wrong.

Which questions can this comparison not answer, and why not?

Three of them, and each is named in turn. The first is which of the two produced more, and a contract cannot settle it, because a contract fixes terms and never results. One invented fund's unit values appear here for a single reason: to show what a high-water mark does in a year when a unit rises. A single invented record over two of its years is not evidence about a structure, an approach, or anybody's future, and reading it as though it were is the second failure named above.

The second unanswerable is suitability. Suitability is not a question about structures at all: it turns on one person's obligations, horizon and tax position, and two people reading the same contract can honestly reach opposite answers without either of them misreading a word. The third is every condition a regulator sets on either side, and those belong at sebi.gov.in.