What Is a Hedge Fund?
High-net-worth individuals often aim for higher returns as they have the ability to take on more risk to get there. Most conventional investment options, like stocks, bonds, and mutual funds don’t allow the kind of high-risk strategies HNIs are looking for. So where do these accredited investors go? They turn to AIFs like hedge funds.
So what is a hedge fund? It is a pooled investment vehicle that can use advanced investing strategies like futures, options, short selling, and leverage to try and generate higher returns. Due to SEBI’s regulations, mutual funds cannot engage in many of these high-risk strategies as they prioritise investor safety.
These funds were introduced in India in 2012 by SEBI under the SEBI (Alternative Investment Funds) Regulations. There are three different categories of AIFs, with hedge funds falling under Category III. This category is specifically made for funds that employ diverse and complex trading strategies.
Like other AIFs, the minimum ticket size to invest in a hedge fund is Rs. 1 crore. This high entry barrier is put in place to make sure that only financially capable investors participate, as the strategies used by these funds carry significant risk.
Hedge Fund Features
- In simple words, hedge fund meaning can be understood as an investment that utilises advanced, more risky strategies to deliver higher returns compared to normal investments.
- A minimum corpus of Rs. 20 crore is required to start a hedge fund.
- Fund managers must also invest a minimum amount in the fund they’re managing.
- Hedge funds have a lock-in period during which no withdrawals are allowed.
- AIFs like hedge funds are less tightly regulated by SEBI compared to options like mutual funds.
- Hedge fund companies charge fees not only for managing the fund but also for the performance they deliver. Management fees are fixed based on the value of assets held by the fund, whereas performance-based fees depend on the fund’s returns.
How Do Hedge Funds Work?
The term hedge means to protect. When you hedge an investment, you take a position to offset profits and losses. Hedge funds go beyond just protection as they use a variety of strategies to not only shield against risk but also to generate high returns. These funds pool money from multiple investors like HNIs and institutional investors and are managed by professional fund managers who actively manage the portfolio using both standard and alternative investment strategies.
So, how does a hedge fund work? Hedge funds use a range of complex techniques such as leveraging, short selling, and derivatives to maximise returns, regardless of how the market moves. Fund managers lower market risk by hedging the fund’s holdings by also allocating some of the fund’s assets into securities that tend to move in the opposite direction of the fund’s main investments. If the core holdings of the fund start to go down in value, the investments in these opposing assets will rise and balance out the losses.
Due to the high minimum requirement, hedge fund investments are not accessible to average investors. If you are considering investing in a hedge fund, you should familiarise yourself with the aggressive strategies fund managers use to deliver above-market average returns. In this regard, guidance from a financial advisor can take you a long way, as professionals can help you understand the risks involved and assess whether hedge funds align with your goals.
What Are the Different Types of Hedge Funds in the Market?
Different types of hedge funds can be classified on the basis of the strategies used by fund managers:
Equity Hedge Funds
In these funds, managers invest primarily in stocks. Apart from taking long positions, managers also take short positions to benefit from both upward and downward market movements. These stocks can belong to either domestic or international companies.
Global Macro Hedge Funds
Managers of such funds make their investment decisions based on broad economic and political events. Investments are made in a wide range of asset classes across global markets. Managers predict large-scale market movements and position the fund accordingly.
Activist Hedge Funds
Activist hedge funds tend to be more involved in the companies they invest in as they buy significant stakes. By doing so they aim to create long-term value by influencing the company’s management decisions, like pushing for restructuring, cost-cutting, or even changing the board.
Relative Value Hedge Funds
These funds exploit temporary pricing inefficiencies between related securities.
What Are the Different Strategies of Hedge Fund Investing?
One cannot completely grasp what are hedge funds without understanding the strategies used by fund managers to generate alpha. Here are a few of them:
- Event-driven strategies: Corporate events such as mergers, acquisitions, takeovers, bankruptcies, or earnings announcements can cause stock mispricing. Hedge fund managers aim to take advantage of these inefficiencies to generate returns.
- Long/ short equity: Fund managers take long positions in stocks they expect to rise and short positions in stocks they expect to fall. Depending on valuation, they focus on companies within the same industry.
- Global macro: Investment decisions are made based on macroeconomic trends like interest rates and currencies, and geopolitical developments.
- Fixed-income hedge: Managers take long and short positions in fixed-income assets to lower volatility. The primary goal of this hedge fund strategy is to protect capital value.
- Leveraging: Leverage is a technique where hedge funds borrow capital to expand their investments. Using borrowed money can help funds generate more returns but this strategy also carries a high degree of risk.
How Are Hedge Funds Taxed?
Tax treatment is one of the most important factors to consider before investing in a hedge fund. Unlike AIF Categories I and II, hedge funds are not considered pass-through vehicles, so they pay tax at the fund level before distributing returns to investors. If a fund’s annual earnings exceed Rs. 5 crore, they are subject to a 42.74% tax rate, which is why the tax burden associated with hedge funds is considered significant. A tax consultant can help you understand the complex tax structure of AIFs and how much of your returns can be eaten up by taxes. They can also create personalised strategies to minimise your tax burden so you get to keep more of your returns.
What are Risk and Return Profile of Hedge Funds?
SEBI does not regulate AIFs as strictly as it does the mutual fund industry, which allows a hedge fund to use risky strategies a mutual fund cannot. These strategies increase the potential for higher returns but they also introduce greater volatility and downside risk to your investment. The minimum ticket size of Rs. 1 crore ensures that no individual without adequate financial capacity enters these high-risk products casually. Some types of risk associated with these investments include:
- Market risk: Hedge funds invest in market-linked instruments so there’s always the risk that market volatility can lead to losses.
- Liquidity risk: Hedge funds have a lock-in period, so your money can be tied up for a specific time.
- Leveraging risk: Using borrowed money to invest is always risky. It can help generate bigger returns but also increases risk.
- Transparency risk: A hedge fund may not be as transparent about its portfolio as a mutual fund.
- Fund manager risk: Managers use complex strategies which may not always pay off, so returns are highly dependent on their expertise.
If you’re an investor chasing high returns, an investment planner can help you understand what you’re signing up for by going for hedge funds. Professionals can assess your finances and risk tolerance and recommend personalised strategies that help you generate high post-tax returns.
Who Should Invest in Hedge Funds?
Hedge funds are not designed for the average retail investor, as is reflected by their high entry barriers and risky strategies. They are mostly aimed at accredited investors who have both the financial capacity and risk tolerance to invest in complex products. These include:
- High-net-worth individuals (HNIs)
- Family offices, and
- Institutional investors like banks, pension funds, and insurance companies.
Wondering how to invest in a hedge fund? A personal financial planner can help you! Since AIF investors are relatively rare in India and hedge funds have a high entry barrier, there isn’t as much information or guidance available as there is for other investments like mutual funds or stocks. Even the best sip planner may not specialise in hedge funds, so it’s important to work with someone experienced in AIFs. They can help you:
- Understand how the fund is structured and the strategies it employs.
- Evaluate the high risks associated with this vehicle and compare them with other alternatives.
- Ensure the fund suits your financial goals and risk tolerance.
- Monitor the investment to ensure it stays on track.
How are Hedge Funds Different from Mutual Funds?
As investment vehicles, there are many similarities between a mutual fund and a hedge fund. Both are pooled investments managed by a professional fund manager who invests the corpus in a diversified basket of securities on behalf of the investors. But there are many differences between the two. So, what are hedge funds compared to mutual funds? Check out this table:
| Factor | Hedge Funds | Mutual Funds |
| Aim | Hedge funds aim to generate returns higher than those delivered by conventional investment vehicles. | Actively managed mutual funds aim to beat their respective indices consistently, while index funds try to replicate them. |
| Risk | Very high due to the complex strategies used by fund managers. | Varies depending on fund category, though generally lower compared to hedge funds. |
| Regulation | SEBI regulates hedge funds, but not as tightly as it does mutual funds. | Strictly regulated by SEBI. |
| Fees | Investors are charged management fees based on AUM as well as performance fees based on returns delivered. | Mutual funds charge a small expense ratio based on AUM. |
| Liquidity | Hedge funds generally offer limited liquidity, but it varies from fund to fund. | Open-ended funds are highly liquid, while closed-ended mutual funds offer limited liquidity. The units of the latter can be sold on stock exchanges. |
| Transparency | Transparency is limited as investments made are only disclosed to the investors of the hedge fund. | Mutual funds are transparent as AMCs regularly publish fact sheets that disclose where investors’ money is being invested, the associated risks, and how the fund has performed. The information is readily available and can be reviewed with the help of a mutual fund advisor. |
| Designed For | HNIs and institutional investors who have the capacity to invest large sums and tolerate higher risk. | Retail investors, but affluent investors like HNIs and institutions also invest in mutual funds due to their wide range of options tailored to a variety of risk profiles. |
| Taxation | As they are non-pass-through vehicles, tax is paid at the fund level. | Mutual fund gains are taxed in the hands of the investors as per their slabs at a comparatively lower rate. |
| Minimum Investment | Rs. 1 crore. | Generally low entry barriers. Some SIPs even allow investors to begin with just Rs. 100. |
Mutual funds can be a highly lucrative avenue for most individuals. If you are seeking benefits like professional fund management, diversification, and liquidity without taking on excessive risk, they can be the ideal investment for long-term wealth creation. Thanks to SIPs, they are accessible even with small amounts. Taxation of mutual funds, especially equity-oriented funds, is also more favourable.
The sheer variety of mutual funds available in the market means there is a fund suited for nearly every financial goal and risk appetite. A mutual fund investment planner can assess your financial situation to recommend the perfect funds to help realise your financial dreams. Contact one today!
Things to Keep in Mind Before Investing in Hedge Funds
Before you invest in a hedge fund, consider the following factors:
- Minimum investment: To invest in a hedge fund at least Rs. 1 crore are required.
- Fund manager’s track record: As returns of a hedge fund are highly dependent on the manager, you must exercise due diligence to ensure there’s no conflict of interest.
- Liquidity: Hedge funds are not very liquid, so your money will be tied up for a specific period before you can withdraw it.
- Complexity and risks: Hedge funds are advanced vehicles which is why they are classified as AIFs by SEBI. Understanding a fund’s strategies is pivotal to understanding the level of risk you’re taking on.
- Taxation: These investments are subject to higher taxes compared to other options. Assess whether the post-tax returns are sufficient for the risk you’re taking.
- Limited availability in India: Hedge funds are relatively new here, so there are limited options to choose from. Read the fund disclosures very carefully, preferably with help from an expert.
- Fees: Investors are charged management as well as performance-based fees, making hedge funds a costly investment.
- Personal considerations: You must ensure that your investment aligns with your financial goals and risk tolerance.
Conclusion
A hedge fund is a pooled investment vehicle where a fund manager uses complex strategies to generate higher returns than traditional investments. SEBI introduced them in 2012 and classified them as Category III Alternative Investment Funds, designed for accredited investors who can handle higher risks.
FAQs
1. Is a hedge fund allowed in India?
Yes, hedge funds were introduced under the SEBI (Alternative Investment Funds) Regulations, 2012. Under these regulations, hedge funds are classified as Category III AIFs.
2. What are the classification of hedge funds?
Hedge funds can be classified based on a number of factors such as investment strategies, underlying assets, and goals. Examples include global macro funds, relative value funds, activist funds, and equity hedge funds.
3. How Do Hedge Funds Compare with Other Investments?
Hedge funds employ advanced investment strategies that are not allowed or commonly seen in other investments such as mutual funds. This is because hedge funds are aimed at accredited investors who possess the risk tolerance needed to handle the volatility that comes with risky strategies like short selling, leveraging, and derivatives.
4. What Tools Do Investors Use to Compare the Performance of Hedge Funds?
Investors use metrics such as the annualised rate of return, Sharpe ratio, alpha, beta, and information ratio to understand the risks and returns associated with a hedge fund. They also look at other factors like fund manager expertise and the fund’s fee structure to make better decisions.
