Hedge funds form a part of an investment model which involves the use of pooled funds that employ various strategies to enable the investors to earn active returns. It makes use of funds collected from accredited investors like banks, insurance firms, individuals or families with a high net-worth, as well as endowments and pension funds. These funds are in turn put into various financial assets, and often function as overseas investment operations or private investment partnerships. The system involves the use of leverage and derivatives to deliver huge returns, therefore minimizing the risk through hedging, i.e. diversification across various instruments of investment. This article seeks to create awareness of this type of investment.
Hedge Fund Portfolio
A hedge fund portfolio comprises of asset classes like derivatives, equities, bonds, currencies and convertible securities. Also known as alternative instruments, these funds tend to employ substantial leverage and is designed to get the benefit of certain identifiable market opportunities. They hold both long and short positions, which includes positions in listed and unlisted derivatives.
Objective of the System
Hedging, in general context, refers to the reduction of risk. That is however not the case in these realms as the object here is to maximize the return on investment through investment means that are considered adventurous.
Hedge funds work in a manner where the assets and sold and procured in a rapid manner, which brings with it an enormous potential for risk. Hence, these funds are typical for a person with surplus funds who is well averse with the concept of investments. The likes of such investors include high net worth individuals (HNIs), banks, insurance companies, etc.
Note: Qualifying investors are required to make a minimum investment of Rs. one crore to be a part of this funding system.
Features of Hedge Funds
The concept of hedge funds is now explained through its various facets.
Type of Investors
As already specified, not all investors qualify for this provision, except for the likes of high net worth individuals, banks, insurance companies, endowments and pension funds.
Hedge funds cover a broad portfolio of asset classes, which includes currencies, derivatives, stocks, real estates, equities, and bonds. This is in stark contrast to mutual funds, where investors are forced to deal with long-term stocks or bonds.
Hedge funds generally provide a higher rate of returns when compared to other investment categories.
Utilization of Leverage
Hedge funds often make use of borrowed money to amplify their returns.
Hedge funds are operated on the concept of both expense ratio and management fee. Fee for hedge funds in India ranges below 2%, whereas that of profit – 20%. This is one of the reasons it is commonly cited as “2” and “20.”
Scope of Risk
Hedge funds investment strategy is not without the potential for losses as the general lock-in period of investment is relatively long, which may turn investments into a significant loss.
As hedge funds are not yet accorded with the pass-through status on tax, income from these funds is taxed at the investment fund level. As a result, the tax obligation will not pass through to the unit-holders.
Hedge funds are not required to be registered with the securities market regulator and hence is devoid of reporting requirements, including regular disclosure of Net Assets Values (NAV).
The strategies involved in hedge funds include:
- Sell Short – where the manager may sell the shares to repurchase them in the future at a lesser price.
- Use of arbitrage – appropriate if the securities have contradictory or inefficient pricing.
- Investment towards an event – here, in this case, market events like acquisitions, mergers, and spin-offs among others may play a role in the manager’s investment decisions.
- Investment in high-discount security implemented where certain companies under financial stress or insolvency decide on selling their securities at a price which is markedly lower.
Risks Involved in Hedge Funds
Investors may do well to consider the following risks before opting for these portfolios of investments:
- These funds involve a concentrated investment strategy, which may lead to potentially huge losses.
- Hedge funds may demand investors to lock up money for a more extended period of time.
- The utilization of leverage may turn a minor loss into a major one.
How does it Differ from a Mutual Fund?
|S. No.||Hedge Funds||Mutual Funds|
|1||Doesn’t qualify for direct advertising||Qualifies for advertising|
|2||Minimum ticket size for investment amounts to Rs. 1 crore||Minimum ticket size for investments is Rs. 500|
|3||Not regulated as it is mostly pursued by forming a partnership between the investors and the fund manager||Highly regulated as it is registered with SEBI|
|4||Periodic disclosure of petition isn’t mandatory||Periodic disclosure of petition is mandatory|
|5||Returns score higher than that of the stock market||Returns are lower when compared to Hedge Funds|
|6||Scope for fraudulence as the investment mode is not transparent||The potential for fraud is negligible as mutual funds are highly regulated by SEBI|
|7||The manager fee hinges on the performance of the fund (apart from the fixed charges)||The performance of the fund is not considered for this purpose|
|8||It is not easily sellable given the lock-in period||Redeemable|
|9||Highly sophisticated strategies are adopted for higher profits||Investment strategies are restricted|
Structure of Hedge Funds
Hedge funds are formed or structured by domestic and/or offshore means. It comprises of:
- Fund Managers
- Administrators and Auditors
- Legal Advisors, Transfer Agents and Registrar
- Prime Broker
- Executing Broker
Types of Hedge Funds
The types of hedge funds include:
- Log-Short Funds – herein, the strategies of both short and long position is practiced by the fund manager. An example of this can be the procurement of cheaper assets to sell it when its rates get higher.
- Event-driven Funds- such funds earn by getting the benefit of the events which drives the market. Events of such kind include political developments, influencing the price of securities, etc.
- Macro Funds – these funds are invested in several types of securities whose price are subject to change due to economic developments.
- Emerging Market Funds – Earnings occur by investing in the securities of the developing economies
- Long-only Funds – these funds earn by anticipating the stock prices to increase in the future by taking long positions
- Merger Arbitrage Fund – earnings occur through the sale and purchase of company stocks which are under merger and acquisition.
- Fixed Income Arbitrage Funds – earnings occur on the basis of price differences offered to the securities in various markets. However, it primarily focusses on the market with a fixed income.
- Distressed Securities Fund – major securities of a company are bought at huge discounts. The investor must be wary of the fact that if the company goes bankrupt, the securities in this fund will be void.
Accredited investors may file a “Hedge Funds Application Form” by specifying information such as their basic details, the source of income, investor classification, tax details, FATCA Declaration, tax status, source of funds for investment, communication preference, investor banking details, investor declaration, etc. As already stated, 2% of the funds will be charged as the management fee along with 20% of the profits.
Foreign investments are of various kinds, here’s your reference to Types of Foreign Investment in India