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

Hedge funds are often seen as the bold side of investing, where returns can be high, but so can the risks. They don’t follow the usual mutual fund route but use flexible strategies to chase better outcomes. It’s not something for every investor, but those who know the game often swear by it. This article walks you through the basics and helps you decide if hedge funds suit your style.

What is a hedge fund?

A hedge fund is a privately managed investment pool that uses many strategies to generate high returns for its investors. Unlike mutual funds, hedge funds aren’t tightly regulated and have the freedom to invest in almost any stocks, bonds, currencies, derivatives, or even real estate. They often aim for absolute returns, meaning they try to make money whether markets go up or down. However, that flexibility also comes with higher risks, limited access, and usually a high entry ticket for investors.

Most hedge funds work like a private setup, where the fund manager runs the show and investors pool their money. These managers usually put in their own money too, so they have skin in the game. What makes hedge funds different is that they don’t just buy and hold; they use tricks like short selling or borrowing to boost profits. But yeah, these are primarily meant for affluent investors or big institutions, not regular folks.

How do hedge funds work?

A hedge fund is just a pool of money collected from a small group of wealthy investors or institutions. The person running the fund is called the hedge fund manager. This manager doesn’t play it safe like a regular mutual fund manager. Instead, they have complete freedom to try different strategies to grow the investors’ money and can make bold moves.

Pooling Money:

First, a hedge fund collects large amounts of money from a few selected investors, usually people with high net worth or big institutions like pension funds.

Choosing Strategies:

The hedge fund manager decides how to invest that money. However, hedge funds go much wider than mutual funds, which mostly stick to buying stocks or bonds. 

Buy stocks they think will go up.

Short-sell stocks they believe will fall (this means borrowing shares, selling them, and hoping to repurchase them cheaper).

Use leverage (borrowed money) to increase the size of their investments.

Trade currencies, commodities, or derivatives like futures and options

Invest in private companies or even distressed assets.

Active Monitoring: 

Hedge funds are very actively managed. The manager constantly tracks the market and makes changes to lock in gains or cut losses.

Fee Structure:

Here’s a significant twist: Hedge funds usually follow the “2 and 20” model. That means:

They charge 2% of the total money managed every year.

Plus, they take 20% of the profits they make. So the manager earns big only if the fund performs well.

Limited Access:

These funds are not open to everyone. SEBI in India and other global regulators usually allow only accredited or high-net-worth investors to invest in hedge funds. The risks are much higher, and strict mutual fund-style rules do not bind them.

Hedge funds aim to make money in all kinds of market conditions, whether the market is going up, down, or sideways. They do this by using complex tools and strategies that most regular investors don’t use. But with high potential rewards come high risks, too.

Types of Hedge Funds

Hedge funds come in many flavours, depending on how they approach investing. Here are some of the most common types:

Long/Short Equity Funds

These funds try to make money by buying stocks that are undervalued (expected to rise) and selling stocks that are overvalued (expected to fall). The goal is to profit on both sides, whether the market goes up or down.

Market Neutral Funds

These take both long and short positions in a way that cancels out overall market movement. Even if the market rises or falls, the fund stays balanced and earns profits purely from the difference between its stock picks.

Event-Driven Funds

They invest based on company-specific events like mergers, acquisitions, restructurings, or bankruptcies. For example, if a company is about to be acquired, the fund might buy its shares expecting a price jump.

Global Macro Funds

These funds take big-picture positions based on global economic trends. They might trade currencies, commodities, bonds, or indices depending on what’s happening worldwide, like interest rate changes or geopolitical events.

Quantitative (Quant) Funds

These use complex algorithms and mathematical models to make trading decisions. Everything is data-driven, and emotions or human judgment are minimal.

Distressed Securities Funds

These look for financially struggling companies that may be on the verge of bankruptcy but have a chance of turning around. The fund buys their stocks or bonds cheaply, hoping to profit when things improve.

Common Strategies Used by Hedge Funds

Arbitrage

They spot price gaps in similar situations. For example, if a stock trades at two different prices in two places, they buy low and sell high instantly, profiting from that tiny difference.

Leverage

Basically, they borrow money to invest more than they actually have. This can boost gains but also make losses bigger if the market turns.

Short Selling

They bet against a stock. They sell first at a high price, then hope the stock crashes so they can buy it back cheap and keep the extra.

Derivatives Trading

Using fancy tools like futures and options to place bets or protect their positions. It’s like predicting where prices are headed without owning the actual stuff.

Tactical Asset Allocation

They keep moving money around, shifting from stocks to gold or bonds based on market conditions.

Who should invest in hedge funds?

Hedge funds aren’t for everyone. They’re mainly meant for people with solid wealth who can afford higher risks. This space might feel too wild if you're looking for stable, predictable returns. However, hedge funds could be an option if you understand the market, are okay with ups and downs, and have a cushion that is big enough to handle losses without panicking. Mostly, they suit high-net-worth individuals or institutions who want to explore aggressive, alternative strategies beyond regular mutual funds.

Who is eligible to invest in hedge funds?

Not just anyone can walk into a hedge fund with some spare cash. You must be a high-net-worth individual (HNI) or an institutional investor in India. SEBI rules say you must invest at least ₹1 crore, which filters out most retail investors. They only allow people who understand risks, can afford to lose money without significant damage, and are financially well-established. You also need to meet certain income or asset criteria to qualify. So yeah, this space is mainly for the big boys with deep pockets.

Hedge Funds vs Mutual Funds

How Are Hedge Funds Taxed?

In India, hedge funds are grouped under Category III Alternative Investment Funds (AIFS) and do not enjoy pass-through status. This means that any income or gains earned by the fund, whether from capital gains, dividends, or interest, are taxed directly at the fund level, not in the hands of individual investors. So, the fund itself pays tax before passing any profits to its investors. This reduces the overall returns that investors receive. Since there’s no tax deferral benefit like mutual funds, the tax burden becomes a significant drawback, especially for domestic investors. It’s one of the main reasons hedge funds haven’t seen widespread popularity in India yet.

Benefits of Hedge Funds

• Offers flexible and aggressive investment strategies.
• Targets profits in both rising and falling markets.
• Helps diversify beyond traditional mutual funds.
• Managed by skilled professionals with skin in the game.
• Uses tools like short selling and leverage to enhance returns.
• Often uncorrelated with stock market performance.

 Risks and Limitations of Hedge Funds

• Carries high risk due to leverage and complex strategies.
• It requires significant capital and is not meant for regular investors.
• Lower transparency in holdings and operations.
• Expensive fee structure, especially the “2 and 20” model.
• Returns are taxed at the fund level, reducing investor payouts.
• Limited liquidity and strict entry/exit conditions.

Conclusion 

Hedge funds aren’t built for the faint-hearted they’re bold, complex, and demand capital and confidence. While they offer the thrill of high returns, they come with risks that not every investor can handle. They can add a powerful edge to your portfolio if you have the potential and understanding. But for most, the safer comfort of mutual funds might still be the better path.