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Hedge Funds – What Are Hedge Funds, Working, Features & Benefits

Updated on: Jun 27th, 2022

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8 min read

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?

CAGR

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

They work 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 fee can well 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 is taxable at the investment fund level. Hence, the tax obligation will not pass through to the unit-holders. This is a disadvantage for this industry as they are not on a level playing ground with other mutual 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 allows these funds to benefit even in the falling markets, which is not so for mutual 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 funds that aim higher 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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Quick Summary

Hedge funds are an alternative investment option managed by experts, targeting high returns. They involve complex strategies to hedge risks, aiming for aggressive management and high fees. They cater to accredited investors like HNIs and have diverse portfolios covering various asset classes. Features include higher risks, fees, and complexity. Returns depend on fund manager's skills, with strategies like short selling and arbitrage. Hedge funds differ from mutual funds in terms of leverage, investor eligibility, and returns.

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