What Are Hedge Funds? Everything You Need to Know

While mutual funds are a familiar investment mechanism, hedge funds offer a unique approach. They, too, pool the funds of numerous investors, but their investment strategies differ significantly. To understand hedge funds, it’s essential to recognize their distinctiveness from mutual funds. Let’s delve into this comparison. 

What are Hedge Funds?

Like mutual funds, hedge funds gather capital from accredited high-net-worth individuals and institutional investors. They aim to achieve high returns by investing in various assets using strategies to minimize risk and maximize investor value.

In 2012, the SEBI introduced hedge funds under the SEBI (Alternative Investment Funds) Regulations. They are categorized as category III alternative investment funds in India but are still in an early stage and need more regulation.

These funds typically operate as limited partnerships managed by professional fund managers. Unlike the SEBI-regulated mutual funds, they are largely unregulated and enjoy more flexibility in their investment strategies.

How do Hedge Funds work?

Due to the significant risks involved and high minimum investment requirements, investment in such funds is limited to accredited institutional investors like pension companies, insurance companies, or high-net-worth individuals. The investors must contribute large sums, accept high risks, and be comfortable with low liquidity. Funds often have a lock-in period, keeping investments tied up for at least a year, with limited withdrawal opportunities. Moreover, the funds need a minimum corpus of Rs.20 Cr. in India, with investors’ contributions of a minimum of Rs.1 crore.

Hedge funds generate revenue primarily through management and performance fees, usually adhering to the 2-and-20 fee structure. Management fees, around 2% of assets under management (AUM), cover operational expenses. The performance fees, usually 20% or above of investment profits, reward successful outcomes and motivate the fund managers.

Furthermore, these funds often employ extreme leverage by using derivatives to amplify returns. While this strategy can lead to sizable profits with minimal capital, it also magnifies losses significantly during market downturns due to the initial modest capital investment.

Types of Hedge Funds:

The funds are categorized into four categories based on the strategies used by the fund managers-

1. Global Macro:

This approach analyzes global economic trends to capitalize on market fluctuations. The fund manager focuses on stocks, bonds, and currencies affected by major macroeconomic shifts, seeking profitable opportunities. This strategy offers diversity and flexibility across multiple markets. However, timing is critical for maximizing returns here. The global macro strategy includes discretionary and systemic trading methods. Discretionary trading relies on manager analysis, whereas systemic trading uses computer models. 

2. Directional:

In a Directional investment strategy, fund managers analyze market movements and trends to select stocks and securities. These investments are sensitive to market fluctuations and include sub-categories targeting specific groups of shares. For instance, “Emerging market funds” concentrate on markets such as China and India, while “sector funds” target particular sectors like technology and pharmaceuticals.

3. Event-driven:

Key corporate events such as acquisitions, recapitalizations, bankruptcies, and liquidations allow hedge fund managers to exploit valuation disparities by forecasting related securities’ movements. Institutional investors in hedge funds possess the resources to analyze these transactions and secure profitable positions.

4. Relative value:

The relative value strategy exploits price differences in securities. Hedge fund managers employ mathematical, technical, and fundamental methods to pinpoint these differences. 

5. Equity Hedge Funds:

These funds focus on stocks, potentially using short selling to hedge against market declines. They aim to profit from stock performance independently of market trends.

Hedge Funds’ Taxation:

Hedge funds in India fall under Category III Alternative Investment Funds (AIFs) and are taxed accordingly. Here’s a breakdown of their taxation:

• Fund-level taxation is followed. Hedge funds are taxed on earnings before distributing profits to investors. This means that investor returns are already taxed at the fund level.
• Investors receive a net return lower than the fund’s total profits.
• Under the Category III AIF taxation, hedge funds are subject to a tax rate of 42.74% on annual earnings that exceed Rs.5 crores. This fund-level taxation means that investor returns AIF lower than the fund’s total profits.

Can I Invest in Hedge Funds?

You can invest in hedge funds, but consider the following factors before deciding-

• Review the Hedge Fund’s Documents and Agreements: This is a crucial step to understand the fund’s strategies, location, and anticipated risks. By doing so, you equip yourself with the knowledge to make informed investment decisions. If you feel the need for investment advisory, consider approaching one that is SEBI-registered.
• Understand the Risk: Financial hedges are highly volatile, so assessing all associated risks is crucial.
• Consider the Cost: The minimum investment of ₹1 crore might be too high for average investors; think carefully before committing as it may also carry a lock-in period.
• Watch for High Fees: Hedge fund fees can significantly impact returns, so understand them before investing.
• Study the Fund Prospectus: Hedge fund strategies differ significantly from other investments, so it’s essential to grasp the prospectus thoroughly.

Conclusion:

Though hedge funds deliver potentially high returns, you should consider multiple factors before deciding on the investment. Given the complexities involved, it is advised to consult a SEBI-registered advisory to better comprehend the funds. You can then explore the hedge funds apart from the long-term stocks to buy if they align with your investment goals. 

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