What are hedge funds and how are they different from mutual funds?

Investing in hedge funds is frequently regarded as a high-risk undertaking. These funds primarily target affluent and high-net-worth individuals and typically demand a substantial minimum investment. This article will take you on a deep dive into this exciting investment opportunity.

• Table of contents

• What is hedge fund?
• Key characteristics of hedge funds
• How do hedge funds work?
• What are the different types of hedge funds in the market?
• What are the different strategies of hedge fund investing?
• What are the risk and return profile of hedge funds?
• Who should invest in hedge funds?
• How are hedge funds different from mutual funds?
• Things to keep in mind before investing in hedge funds

What is a hedge fund?

A hedge fund functions as a pool of capital sourced from private investors and entrusted to the expertise of professional fund managers. These funds are characterized by their active and aggressive management styles, aiming to deliver positive returns irrespective of prevailing market conditions.

The fund managers leverage various strategies, including the utilization of borrowed funds (leverage) and the trading of non-traditional assets, in their pursuit of above-average returns. Renowned for their flexibility, hedge funds can engage in both traditional and alternative investment approaches.

Key characteristics of hedge funds

Exclusivity: Hedge funds typically cater to high-net-worth individuals, institutional investors, and those meeting specific financial criteria.

Diverse investment strategies: Hedge funds employ a wide spectrum of strategies to achieve their return objectives. These strategies may encompass long and short stock positions, leverage, derivatives trading, arbitrage, and various other techniques.

Fee structure: Hedge fund managers typically charge both management and performance fees. The management fee is calculated as a percentage of the total assets under management, while the performance fee is a percentage of the fund's profits.

Leverage utilization: Hedge funds often employ leverage, or borrowed capital, to amplify their investment positions. While leverage can potentially magnify returns, it also escalates the level of risk and potential losses.

Flexibility and adaptability: Unlike traditional funds, hedge funds afford investors the flexibility to invest in a diverse array of assets, including stocks, bonds, currencies, commodities, and derivatives.

Risk management emphasis: While hedge funds strive for high returns, they also prioritize risk management. Robust risk assessment models are often integral to their strategies, and many hedge fund investors rely on sophisticated risk management techniques.

Limited regulatory oversight: Hedge funds often operate under less stringent regulatory scrutiny compared to mutual funds. This grants fund managers greater autonomy.

How do hedge funds work?

Hedge funds aggregate capital from substantial investors, including high-net-worth individuals, endowments, financial institutions, pension funds, and corporations. Classified as Category III Alternative Investment Funds (AIFs), these pooled resources are deployed across a spectrum of securities in both domestic and international markets.

The investments are made in a wide range of assets encompassing equities, bonds, real estate, currencies, convertible securities, and derivatives, among others.

Furthermore, hedge funds frequently leverage borrowed capital to amplify their investment positions. Short-selling, another common strategy, allows hedge funds to profit from declining asset prices, further contributing to their dynamic investment approach.

What are the different types of hedge funds in the market?

There are distinct categories of hedge funds based on its investment focus and strategic approach:

1. Global macro hedge funds: These funds capitalize on macroeconomic trends and financial conditions, such as inflation rates, to generate returns from market movements.
2. Relative Value Hedge Funds: These funds aim to achieve profitable outcomes by exploiting price discrepancies between related securities.
3. Activist hedge funds: These funds invest in companies and exert influence to implement changes, such as cost-cutting measures or asset restructuring, with the goal of enhancing shareholder value.
4. Equity hedge funds: These funds primarily invest in domestic and global stocks, seeking to provide downside protection against equity market downturns through strategies like short selling overvalued stocks or stock indices.

Beyond these broad categories, hedge funds can be further classified based on their geographical location and investment structure:

Offshore hedge funds: Domiciled in low-tax jurisdictions, these funds are accessible to investors worldwide.

Domestic hedge funds: These funds are available to investors subject to the taxation laws of the country in which they are based.

Fund of funds: This unique type of mutual fund invests in a diversified portfolio of hedge funds rather than individual stocks or bonds.

What are the different strategies of hedge fund investing?

Hedge funds employ a wide array of intricate strategies to manage their investments and pursue returns. Some of the most prevalent strategies include:

1. Event-driven: These funds capitalize on price movements triggered by corporate events, such as mergers, acquisitions, or restructurings. Examples include merger arbitrage funds and distressed asset funds.
2. Market neutral: These funds aim to minimize market risk by employing strategies like convertible bond arbitrage, long/short equity, and fixed-income arbitrage.
3. Long/short selling: This strategy involves taking both long (buying) and short (selling borrowed securities with the expectation of repurchasing them at a lower price in the future) positions in securities to profit from both rising and falling markets.
4. Arbitrage: This strategy seeks to exploit price discrepancies between related securities or markets. Relative value arbitrage, for instance, involves simultaneously buying and selling two highly correlated securities to profit from temporary price differences.
5. Market-driven (Global Macro): These funds analyze global macroeconomic trends and their potential impact on interest rates, equities, commodities, and currencies to inform their investment decisions.
6. Quantitative: This strategy relies on mathematical models and algorithms to identify and execute investment opportunities.

What are the risk and return profile of hedge funds?

While SEBI maintains some level of oversight, the absence of strict legal bindings contributes to an elevated risk profile.

Hedge funds, true to this principle, have the potential to offer higher returns commensurate with their elevated risks. The expertise of hedge fund managers can potentially lead to average annual returns reaching as high as 15%.

Who should invest in hedge funds?

Hedge funds are most aligned with the needs of affluent investors who have surplus funds and are comfortable assuming additional risk in pursuit of potentially higher returns. They primarily cater to a select clientele, including high-net-worth individuals, institutional investors, banks, insurance companies, and pension funds. These investors typically possess substantial capital and access to expert financial advice, enabling them to navigate the complexities and risks associated with hedge fund investments.

Moreover, the minimum investment requirement for hedge funds in India is set at Rs. 1 crore, effectively limiting their accessibility to the general public. Furthermore, these funds carry inherent high risks and are subject to significant taxation, factors that warrant careful consideration.

How are hedge funds different from mutual funds?

Hedge funds and mutual funds, while both serving as collective investment vehicles, exhibit significant differences in terms of their strategies, fee structures, investor eligibility criteria, and liquidity provisions.

Things to keep in mind before investing in hedge funds

Here are some essential factors to consider when investing in hedge funds:

Complexity: Hedge funds employ sophisticated investment strategies that may not be readily comprehensible to all investors.

Risk-return dynamics: The pursuit of higher returns often entails assuming greater levels of risk.

High entry barrier: The substantial minimum investment requirement of ₹1 crore significantly limits accessibility to these funds.

Volatility of returns: Hedge fund returns can be unpredictable and subject to significant fluctuations.

Fund documentation: Thoroughly review the fund's offering documents and agreements to gain a comprehensive understanding of its investment strategies, geographic focus, and anticipated risks.

Fee structure: Hedge funds typically charge both management and performance fees, which can impact net returns.

Regulatory landscape: In India, hedge funds operate under a less stringent regulatory framework compared to mutual funds.

Liquidity constraints: Hedge funds may impose restrictions on withdrawals or redemptions, limiting your ability to access your capital.

FAQs:

Why do people invest in hedge funds?

A common motivation to invest in hedge funds is their potential to deliver attractive returns through specialized strategies and experienced management.

How to invest in hedge funds in India?

To invest in hedge funds fulfilling the eligibility criteria as an accredited investor is a must. This entails possessing a certain level of financial sophistication and net worth, as stipulated by regulatory guidelines. The next step involves identifying suitable hedge funds and completing the necessary documentation and fulfilling any additional requirements set forth by the fund manager.

What is a hedge fund vs mutual fund?

Hedge funds are investment funds targeting high returns through riskier strategies, often for wealthy investors. Mutual funds pool money from many investors to invest in a diversified portfolio of stocks, bonds, or other assets, with lower risk.

What are the classification of hedge funds?

Hedge funds can be classified into various strategies such as long/short equity, event-driven, macro, quantitative, and distressed securities, each with unique approaches to generate returns by managing risk and market movements.

Are hedge funds regulated by SEBI?

Hedge funds in India are not directly regulated by SEBI like mutual funds, but they must comply with regulations under the Securities and Exchange Board of India (Alternative Investment Funds) regulations, which govern investment practices for private funds.

Is hedge fund legal in India?

Yes, hedge funds are legal in India but are classified as Alternative Investment Funds (AIFs) under SEBI regulations. They are allowed to operate within the regulatory framework set by SEBI for private investment vehicles.

Why are hedge funds so rich?

Hedge funds are often rich due to their ability to use high-risk strategies, leverage, and access to exclusive investment opportunities that can yield significant returns, especially when managed by highly skilled fund managers.

Who runs hedge funds?

Hedge funds are typically run by portfolio managers who have expertise in various financial strategies. These managers are often experienced professionals with backgrounds in finance, economics, or quantitative analysis.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.