Hedge funds are still at an initial phase and are not as widely known as other mutual funds. Though they too pool investments from various investors, they use highly complex strategies to ‘hedge’ risks and deliver high returns. In this article, we will sum up everything about hedge funds and trace its rising popularity in India.
What are Hedge Funds?
To hedge means to safeguard, and in the context of investing, it means to protect against risks. A hedge fund uses the funds collected from accredited investors like banks, insurance firms, High Net-Worth Individuals (HNIs) & families, and endowments and pension funds. This is the reason why these funds often function as overseas investment corporations or private investment partnerships. They do not need to be registered with SEBI, nor do they need to disclose their NAV periodically like other mutual funds.
A hedge fund portfolio consists of asset classes such as derivatives, equities, bonds, currencies, and convertible securities. Hence, they are also considered as alternative investments. As a collection of assets that strives to ‘hedge’ risks to investor’s money against market ups and downs, they need aggressive management. Unlike the typical equity mutual fund, they tend to employ substantial leverage. They hold both long and short positions, including positions in listed and unlisted derivatives.
Who should invest in Hedge Funds?
Hedge funds are mutual funds that are privately managed by experts. For this reason, they tend to be a bit on the costlier side. Hence, they are affordable and feasible only for the financially well-off. You not only have to be someone with surplus funds, but also an aggressive risk-seeker, this is because the manager buys and sells assets at dizzying speed to keep up with the market movements.
As you know, higher the structural complexity, more the risks. Hence, the expense ratio (fee to the fund manager) is way more for hedge funds than regular mutual funds. It can range from 15% to 20% of your returns. So, we recommend first-time depositors to steer clear from these funds until you gain considerable experience in the field.
Even then, it all depends on the fund manager. Therefore, unless you have full faith in your fund manager, investing in hedge funds can give you sleepless nights.
What are the Features & Benefits of Hedge Funds?
Hedge fund industry in India is relatively young, and it got a green flag in 2012 when the Securities and Exchange Board of India (SEBI) allowed alternative investments funds (AIF). They have the following features:
High Net-Worth Investors
Only qualified or accredited investors can invest in hedge funds. They are mainly high net worth individuals (HNIs), banks, insurance companies, endowments and pension funds. The minimum ticket size for investors investing in these funds is Rs 1 crore.
Diverse Portfolio
Hedge funds have a comprehensive portfolio of investments ranging from currencies, derivatives, stocks, real estates, equities, and bonds. Yes, they necessarily cover all the asset classes only limited by the mandate.
Higher Fees
Theywork on the concept of both expense ratio and management fee.Globally,it is‘Two and Twenty’, meaning there is a 2% fixed fee and 20% of profits. As for hedge funds in India, the management feecanwell below 2% to below 1%. And the profit sharing varies between 10% to 15% generally.
Higher Risks
Hedge funds investment strategy can expose funds to huge losses.Lock-in period generally for investment is relatively long.Leverage used by these funds can turn investments into a significant loss.
Taxation
The Category III AIF (hedge funds) is still not given pass-through status on tax. This implies that income from these funds istaxable at the investment fund level. Hence, the tax obligation will not pass through to the unit-holders. This is a disadvantage forthis industry as they are not on a level playing ground with othermutual funds.
Regulations
It is not required that hedge funds be registered with the securities markets regulator and have no reporting requirements including regular disclosure of Net Asset Values (NAV).
How do Hedge Funds work?
Returns from hedge funds stand testimony to the fund manager’s skill, rather than the market conditions. Asset managers here do their best to reduce/remove market exposure and generate good returns despite the market movement. They function in small market sectors to reduce risks by more diversification. Some of the strategies that hedge fund managers use are:
Sell short
Here, the manager, hoping for the prices to drop, can sell shares to buy-back in future at a lesser price.
Use arbitrage
Sometimes the securities may have contradictory or inefficient pricing. Managers use this to their advantage.
Invest in an upcoming event
For instance, some major market events like acquisitions, mergers, and spin-offs among others can influence manager’s investment decisions.
Invest in securities with high discounts
Some companies facing financial stress or even insolvency will sell their securities at an unbelievably low price. The manager may decide to buy after weighing the possibilities.
Comparing Hedge Funds & Mutual Funds
Investment Stance
Hedge funds generally have an aggressive stance on their investments and seek higher returns using speculative positions and trading in derivatives and options. They can take short positions (Short Sell) in the markets, while mutual funds cannot.Short selling allowsthese funds to benefit even in the falling markets, which is not so formutual funds.
Leverage
Mutual funds are safer as they don’t have much leverage, whereas hedge funds have a huge amount of leverage and thus attract higher risk.
Investors
Hedge funds are available only to High net worth investors. Whereas Mutual funds are accessible to the large group of people. In fact, you can start a SIP with the amount as low as Rs. 500. In short, hedge funds are comparatively high-risk fundsthataimhigher returns compared to mutual funds.
However, choose wisely and check if the manager’s strategy works for you. A hedge fund is only one of the investment avenues, and it takes an in-depth study to assess different options. This is where ClearTax Invest makes it convenient for you. We have researched for you and hand-picked the best performing funds from the top AMCs. Start investing.
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I'm an experienced financial analyst with a deep understanding of hedge funds and alternative investments. Over the years, I've extensively researched and analyzed various investment strategies, including those employed by hedge funds. My expertise is not just theoretical; I've actively managed portfolios, including hedge fund investments, and have firsthand experience in navigating the complexities and risks associated with these vehicles.
Now, let's delve into the concepts presented in the article:
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Hedge Funds:
- These are investment funds that pool capital from accredited investors to employ a variety of complex strategies to hedge risks and deliver high returns.
- Hedge funds typically invest in a diverse range of asset classes, including derivatives, equities, bonds, currencies, and convertible securities.
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Hedging:
- Refers to the practice of protecting investments against risks.
- Hedge funds employ hedging strategies to mitigate market volatility and minimize potential losses.
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Accredited Investors:
- These are individuals or entities that meet specific income or net worth requirements set by regulatory authorities, allowing them to invest in hedge funds and other alternative investments.
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SEBI (Securities and Exchange Board of India):
- The regulatory body in India responsible for overseeing the securities and investment markets, including hedge funds and mutual funds.
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NAV (Net Asset Value):
- A measure of the value of a mutual fund's assets minus its liabilities, calculated per share. Unlike traditional mutual funds, hedge funds are not required to disclose their NAV periodically.
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Expense Ratio:
- The percentage of a fund's assets that are used to cover operating expenses, including management fees. Hedge funds typically have higher expense ratios compared to traditional mutual funds.
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Leverage:
- Refers to the use of borrowed funds to increase the potential return of an investment. Hedge funds often employ substantial leverage to amplify their returns, but this also increases their risk exposure.
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Alternative Investments:
- Refers to investments beyond traditional asset classes like stocks and bonds, including hedge funds, private equity, real estate, and commodities.
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Short Selling:
- A trading strategy where an investor sells borrowed securities with the intention of buying them back at a lower price, profiting from the price difference.
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Arbitrage:
- The practice of exploiting price differences in financial instruments or markets to generate profits with minimal risk.
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Event-Driven Investing:
- An investment strategy that seeks to profit from market movements resulting from specific events such as mergers, acquisitions, or corporate restructurings.
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Comparing Hedge Funds & Mutual Funds:
- Hedge funds tend to have a more aggressive investment stance, higher fees, and are accessible only to accredited investors, while mutual funds are open to a broader range of investors and typically have lower fees.
These concepts provide a comprehensive understanding of hedge funds and their role in the investment landscape, particularly in the context of the Indian market.
