Hedge Funds

What is a Hedge Fund?

Hedge Fund primarily protects against investment risks using pooled money from accredited investors. In other words, they hedge risks to deliver high returns while using complex strategies to invest in non-traditional asset classes.  

Functionally, Hedge Funds are private investment partnerships or overseas investment corporations. They are not registered with SEBI and do not need NAV disclosure daily unlike mutual funds. 

The minimum investment in Hedge Funds is very high, practically eliminating investors who are not wealthy. It also implies that the charges applied are higher than other traditional investment funds. 

Hedge Fund Categories

Hedge Funds are categorized on broadly adopted strategies and designed to cash in on their specific market windows. Hedge Fund under this category is either event-driven or fixed-income arbitrage. The other classification used for Hedge Funds is based on the fund manager’s investment style. 

Regardless of the category, Hedge Funds are illiquid as the investment is locked up for pre-determined periods. Moreover, withdrawal is permitted in fixed quarterly or annual intervals.

Features and Benefits of Hedge Funds

The Indian Hedge Fund industry is nascent, having received the SEBI’s green signal only in 2012 as an Alternative Investment Fund (AIF). The fund’s salient features are:

• Select Investors: Investment in the fund suits high net-worth individuals (HNIs), Banks, Insurance Companies, Endowments, Pension Funds, and similar entities who can afford the minimum Rs. 1 Cr investment. 

• Diversified Portfolio: The Hedge Fund portfolio comprises diverse asset classes comprising derivatives, currencies, stocks, real estate, and bonds, limited by the mandate.  

• Wide Latitude: Hedge Fund Managers enjoy extensive latitude despite being limited by its mandate. The fund manager can invest in any asset class – derivatives, stocks, currencies, land, and real estate, to name a few. 

• High Risk: The asset classes in the portfolio are prone to suffer huge losses due to the investment strategy. Moreover, the long lock-in period can turn the investment sticky, resulting in losses. 

• High Fees:  You have to bear higher charges in the Hedge Funds comprising expense ratio and management fee. The globally accepted rates are defined as ‘Two and Twenty,’ which boils down to a fixed 2% fee plus 20% of the profits. However, in India, you pay a management fee of 2% or 1%, while profit sharing is between 10 and 15%. 

Who are the Potential Hedge Fund Investors?

Hedge Funds, unlike mutual funds, are managed privately by experts. Since the cost of operations and the minimum investment is high, investment in the fund is restricted to the wealthy. However, only financial wealth does not suffice as the investor must be an aggressive risk seeker. 

Moreover, the fund manager keeps pace with the rapid market movements. Accordingly, the investor must match the dizzying speeds at which the assets are bought and sold with the sole aim of booking profits. 

Therefore, you must repose full faith in the fund manager else steer clear from investing in Hedge Fund.  

How Does the Hedge Fund Work?

The returns from Hedge Funds are not as dependent on the market conditions as on the fund manager’s skill in capital asset allocation and the traded asset classes. It is the fund manager’s maneuvers that yield returns rather than the asset class. 

Accordingly, strategies evolve around diversified exposure to reduce risk. Some of the common ploys used by the fund managers are:

• Sell Short: The fund manager sells the shares when the prices are expected to drop. The future buy-back at lower prices is the key to exceeding returns over investment. 

• Use Arbitrage: Fund managers are known to take advantage of inefficient and contradictory pricing in securities. 

• Explore Upcoming Events: Sometimes, market events present themselves, opening a window of opportunity. For example, a fund manager decides to invest if acquisitions, mergers, and spin-offs appear on the horizon. 

• Discounted Securities: Your fund manager never loses an opportunity to cash distress-sale of company shares. Usually, such purchases at unbelievably low prices are sealed after meticulous analyses of the pros and cons. 

Risk Perceptions in Hedge Funds

Hedge Fund investments are considered risky as a strategic move to cushion potential losses. Usually, Hedge Funds are constantly on the lookout for outsized returns. Fund managers are not shy of using any investment strategy from the available options focused on profits. They are even ready to invest in speculative instruments to explore higher returns.

Let us check out how:

• Hedge Funds are exposed to potential losses in a concentrated investment strategy. 

• Investors must factor in a lengthy lock-in in Hedge Fund investments. 

• Minor losses can become huge when you use borrowed money or leverage for Hedge Fund investment.  

Hedge Funds and Other Investments

Hedge Funds are similar to other investments like the Mutual Fund and Exchange-Traded Fund (ETF) as they are primarily money pools collected from multiple investors. 

The other distinguishing elements are:

• Hedge Funds are privately managed with the sole aim to exceed market returns.

• Fund managers take significant risks to ensure the highest returns through Hedge fund investments. 

• Hedge Funds enjoy greater flexibility than other instruments as they are not SEBI registered and loosely monitored. 

• The charges applied in Hedge Funds are much higher than other comparable instruments.

In Conclusion

Hedge Funds offer a rare opportunity to the wealthy investors for highest returns. However, they are risky investments and not open to investors who do not pursue risk aggressively. 

Despite being a young investment option, the expert fund managers are steering Hedge Fund investments by adopting complex strategies to maximize returns. You must always take professional advice before investing in a hedge fund.

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