Hedge funds are privately owned and managed mutual funds. They are unregistered private investment funding groups which can trade into equities, derivatives, debt securities etc. Hence they can trade into financial instruments kike securities, non – securities and derivative. These funds are owned by private companies and they are not liable to answer to SEBI for their NAV or any other information. The risk profile of such companies is very high which means that the returns are also very high. Such funds raise money from HNIs (high net worth individuals), banks, pension funds, corporate, MNCs, endowments etc.
Hedge funds function under category 3 of the alternative investment funds (AIF). The polled money is used for investment activities in domestic and international markets. The investment is done through various trading techniques executed by the fund managers. The fund manager takes the risk on behalf of the investment group and the returns are distributed among the investors. The average return rate is set at 15% per year in such funds. They trade into equities, commodities, currency, real estate, convertible securities, bonds, etc.
Compliance with Regulatory Framework
Hedge funds are not required to function under SEBIs regulatory framework for mutual funds. Unlike mutual funds they do not have any regulatory requirements. It is not compulsory for such funds to disclose their NAVs, investment portfolio, risk diversification etc. However SEBI does make sure that such funds don’t exploit the investor class through over risky investments.
Any private investment fund with more than 20 crore of corpus can become a hedge fund. Also such funds usually allow the money inflow from investors over 1 crore Rs. only. This means that any investor with less investment than 1 crore Rs. is not allowed into such funds.
They work under the category 3 of the alternative investment funds (AIF). Also they are taxed as per the rules mentioned in that section only.
Who Invests in Hedge Funds and Why?
Hedge funds are high profile funds which are managed rigorously by the managers. The managers perform a high number of transactions and go through various trading techniques during the execution. All this renders at least 15% returns to investors. The hedge funds can be started with a minimal investment of 20 crore Rs. as well. But the investor class in hedge funds are qualified or accredited investors, the minimum entry into hedge funds range from 1 crore Rs onwards. Being privately managed they are a bit costlier. Hence only the financially well-off can afford it. These funds are aggressive risk takers and they tend to have a very thin line for safe bets. Higher risks means higher returns but it also includes possibilities for higher losses. Hence one who invests in them is capable of bearing that high amount of loss.
The expense ratio is really high in such funds. The managers and company together take away almost 18 – 20% of the returns as their fees. Hence the returns are highly expensive. Also it is advised that only experienced people should opt for these schemes because of the complexity in their methods of trading and returns. One should have full faith in the fund manager before investing into hedge funds because he is the one taking risks on your behalf.
Different Strategies Used by Hedge Funds
Hedge funds tend to use various sets of strategies while performing transactions in the open market. Some of the most used strategies are :
- EVENT BASED
- SHORT SELLING
- ARBITRAGE
Event Based
The market and stocks respond to events. There are instances when in lieu of certain events the stock valuation increases and due to this there is a better chance of high returns. The earlier a person enters into a position the better returns he gets. One such instance is Dr. Reddy’s Labs. The day when the Russian vaccine Sputnik tied up with it for production and marketing of vaccines in India, the stock price increased significantly. The news was so positive that the stock price increased almost 25% in valuation within 5 days. Hence event based trading is always beneficial.
Short Selling
This is a very frequently used tool nowadays. The fund managers do a calculative evaluation of stocks and market and short the same. In events of bad news or bad economic condition or worse situation the fund managers take a shorting position and make money by selling the shares and indices and buying them later. Hence short selling is a new way of making money in market. It is always said that having a bullish trend in the market is good but it takes a long time to build up. On the contrary when the bearish trend sets on the entire gains of a week or so are washed up in merely a day or two.
Arbitrage
It is associated with the fundamental of buying a security at lower price from one market and selling that into another market at higher price. The profits come from the price difference in this type of trading technique. The securities belong to the same or different asset class on the basis of the estimation by the manager.
Difference Between Hedge Funds and Mutual Funds
| PARTICULARS | HEDGE FUNDS | MUTUAL FUNDS |
| INVESTORS | High net worth individuals, banks, corporate houses and commercial firms | Any investor who has a domestic existence |
| RISK | Highest | Lower than hedge funds |
| REGULATORY | No SEBI requirements | SEBI registration is mandatory |
| MINIMUM VALUE FOR ENTRY | 1 Crore Rs. | Starts from 500 Rs minimum |
| MINIMUM VALUE TO BE CLASSIFIED | 20 crore Rs | Not fixed or defined |
| STRATEGIES FOR INVESTMENT | They pursue all the strategies but one unique feature is short selling is permitted | They are not allowed to create a short selling situation |
How Hedge Funds Work ?
Hedge funds are having a complex structure in working. They invest in all the securities possible to have a diversified portfolio. This enables them to get a benefit in market movements and balances their investments. However the strategies they perform like arbitrage and short selling exposes them to higher risks.
They gather a large number of funding from different investor classes and utilize them in proportion of their investment the year around. The fees of funds are set very high because of their higher return guarantees. They have to perform significantly well so that they can render 15 – 20% returns per year. They perform investment domestically and in international markets. Their investments open up a path for diversity in holdings and positions. They have a material fee of around 2 – 3% and the profit sharing ratio is close to 15 – 20%. This sums up their fees from 20 – 25% annually.
What Should One Consider Before Investing into Hedge Funds ?
Before investing into hedge funds one should know about the fund manager and his background. Also the person should be well aware about the trading techniques and strategies used by the fund manager. The person should know that the risk ratio is high in every hedge fund so we should select a fund with higher valuation in the form of investment. Also people should notice the diversification of the hedge fund in various segments.
The main elements to keep in mind is what is the history of hedge funds in terms of risk and return policy. The amount of returns handled around the year determines what the hedge fund actually performs the year around. It is a sign of how their money is utilized and how much return is expected. If one does not get at least 15% return from the fund it is advisable to invest. The reason is in the normal market the interest rate for money given is 12% and hence giving away money with more risk profile and just receiving 3% extra is a foolish move for risking the entire capital. Hence all these things should be kept in mind before investing into a hedge fund.
