Updated on September 13, 2024
Written by Manish Kothari
CEO Zfunds
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A hedge fund is a pool of funds from a high-income and high-risk investor group, which is managed by a fund manager and invested into equity, debt, Bonds, real estate, currency, or other derivatives in national and international markets.
The group of investors may include high-net-worth individuals, banks, pension funds, or firms. As hedge funds are not as regulated by SEBI as mutual funds, the risk is higher and so are the fund management fees. Also, there is a high minimum investment limit for this institutional or accredited group to invest in the hedge fund.
There are various types of hedge funds according to the strategies they use to invest or the types of assets they invest in.
1.) Type of Investors: Investments in hedge funds are made by the affluent class of investors owing to their high ticket sizes. Generally, High net worth investors (HNIs), UHNIs, Insurance companies, Banks, and pension funds make investments in hedge funds.
2.) Portfolio: Hedge funds can have a diversified portfolio consisting of investments like equities, equity-related instruments, derivatives, futures, bonds, other fixed-income instruments, etc. The portfolio of a fund would depend upon the Investment strategy followed by the fund.
3.) Investment requirements: Hedge funds have high minimum investment requirements i.e the minimum ticket size as per SEBI rules is Rs.1 crore. Due to its high investment requirements, this type of AIF is preferred only by wealthy investors.
The minimum assets required for the hedge funds to operate is set at Rs.20 crores as per the SEBI rules. Also, the promoter or fund manager needs to make their mandatory contributions of 5% of its assets or Rs.10 crores whichever is lower as per the SEBI requirements to protect the interests of investors.
4.) Risk: The hedge funds aim to reduce & protect the downside risks through their opposite exposures in relative asset classes and therefore, pocketing the arbitrage. Also, as per their investment strategies, they would make investments in a way that they have a very low correlation with traditional investments like equities, mutual funds, etc. So it is not mandatory that if the stock markets fall then the hedge funds will also experience falls, as their motive is to protect the investor's wealth by reducing downside risks.
5.) Returns: The returns from hedge funds can be higher than those of the other investment options because they deploy highly complex strategies to earn extra returns. At times of economic uncertainties, hedge funds have the potential to offer higher returns than equity markets. Also, it has been seen that when markets were at their decade lows amid the pandemic in March of 2020, some of the hedge funds were able to deliver positive & good returns despite the gloomy market conditions.
6.) Fees or Costs: Globally, the hedge funds industry has a fee structure of "2 and 20 annually" where 2% is the fixed management fee of the investor's assets. And 20% is the performance fee, which means if the fund can offer positive returns or like above the specified hurdle rate then the fund will be charging a fee of 20% on the profits.
However, the fee structure can be fund-specific and would be charged as per the structure of a particular hedge fund.
7.) Taxation: Hedge funds are high taxable investments and the taxes on these investments are higher than other investment instruments. The Category-3 AIF still does not have the tax pass-through status in India which means the taxation on the capital gains on investments is done at the fund level and no tax obligation is passed to the investors.
As per the tax rules, the tax rate for the Category-3 AIF comes out to be around 43%.
8.) Liquidity: These investments are generally less liquid because they have a lock-in period on investments where withdrawals are restricted. The lock-in period requirements vary across funds.
Investments in these funds provide very little liquidity to the investors as compared to other investment options like mutual funds, and stocks where they can sell anytime as per their will.
9.) Regulations: The category-3 AIF along with the other AIFs comes under the regulations of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.
Read more about : NISM Certification
About regulations & transparency, the hedge funds are not as transparent as other investment products. Also, they do not have strict regulation requirements like others.
Some of the common hedge funds strategies are listed below that people and other financial institutes follow
1.) Long-Short: In the Long-Short investment strategy, the fund manager trades pairs of stocks in the same industries. They would go long on the stock which is expected to perform well and short on the stock which is expected to underperform, thereby gaining the difference. For example- If the fund manager expects Infosys to perform better than Wipro then he will go long on Infosys and short on Wipro.
2.) Global Macro: Global Macro Strategy is an investment strategy based on the global economic outlook & ongoing trends in the economies which are expected to affect the prices of different asset classes. The manager will go long/ short on different asset classes like currencies, equities, bonds,real estate, commodities, etc. based on the expectations from the economic scenarios.
3.) Event-driven: Event-driven strategies are based on the expectations of corporate events like restructuring, mergers, acquisitions, buybacks, bankruptcy, etc. This strategy involves taking long/short positions in stocks based on impacts that are likely to happen from corporate events. For example, the hedge fund manager would go short on the stock of a company that is likely to file for bankruptcy shortly.
4.) Fixed Income Arbitrage: Here, the fund managers would buy/sell fixed income securities like government bonds, corporate papers & other bonds and aim to benefit from the price differences for the same securities in other markets by selling there and therefore, pocketing the difference.
5.) Relative Value Strategies: These strategies work when the market is moving sideways. The strategy involves going short/long on highly correlated investment instruments to pocket from the price discrepancies. For example- The fund manager would buy one security of a company and short-sell the other security of the same company(high correlation because the same issuer).
6.) Short Only: This strategy involves going short on the securities which are overvalued or are expected to fall shortly due to some internal or external events. The fund manager might go long sometimes even using this strategy but the overall trade would involve a larger portion of selling short.
7.) Quantitative: In a quantitative strategy, the hedge fund uses technical analysis, quantitative modeling, and algorithmic models to make investment decisions regarding buying or selling securities in the market.
8.) Multi-Strategy: Multi-Strategy hedge funds use a variety of investment strategies to make decisions regarding entering into trades in the market. They just do not depend upon one strategy and instead use multiple strategies at different times to generate returns according to market conditions.
9) Arbitrage: It is one of the best strategies in which security is bought when it is trading at a lower price in one market and selling in another market at comparatively higher prices.
10) Balance market risk: One of the common strategies is to invest in market-neutral assets like convertible bonds and long and short-term equity funds.
Hedge funds are not suitable for everyone. They are designed for wealthy or high net-worth investors because these funds have high investment requirements. These funds deploy complex investment strategies to generate returns, so investors need to understand the higher levels of risks associated with their capital.
Hedge funds may be a good option for experienced investors looking for diversification, non-traditional investment strategies, or the potential for higher returns. But choosing a hedge fund for investment also becomes difficult due to the low transparency & disclosure requirements as per SEBI rules. Investors should spend a fair amount of time choosing between different hedge funds for investments as not all funds in India or across the globe can generate positive or efficient returns for the investors.
One of the most common ways of understanding the performance of Hedge funds is to compare their annual rate of return. To make this comparison there are various analytical software available online for free.
You can invest in hedge funds if you have surplus funds, you have a trustworthy highly experienced fund manager and your risk and return appetite is high.
Hedge funds are taxed as funds as a whole and are not passed to individuals or institutions investing in them. So the returns generated will be taxed first and then it will be distributed among the investors. It lowers the overall returns generated by the fund annually. In India, hedge funds are taxed under category III AIF in the Indian Taxation Act and it does not have pass-through status.
| Hedge Funds | Mutual Funds | |
| Investors | Few number of investors | A large number of investors |
| Types of investors | HNIs, UHNIs, Insurance Companies, Banks, Pension Funds, etc. | Mostly preferred by the retail investors |
| Management | Actively managed | Actively managed except in the case of index funds |
| Costs | Have the fixed management fees and percentage of the profit. | A fixed percentage on the AUM known as the expense ratio |
| Minimum investment | High requirement. As per the SEBI rules, the minimum investment is Rs.1 crore | Low minimum requirements. Generally, it is Rs.500 and starts from Rs.100. |
| Liquidity | Less liquid | Highly liquid |
| Risk | Have higher risk as they use complex investment strategies | Depends upon the investment objective of the fund |
| Return | High potential returns | Depends upon the market conditions, chosen asset class, investment horizon, etc. |
| Transparency | Low transparent | High transparent |
| Taxation | Comes under category 3 of AIF. Doesn’t have a tax-pass through status in India. Tax comes out to be around 43% | Taxed as per the LTCG and STCGs. Debt and equity have different tax rates |
| Regulations | Low regulations | High regulations |
A. Hedge funds pool the investment from affluent investors and invest them in different asset classes as per the objective. It makes complex investment strategies to generate high returns and reduce or protect the downside risks.
In simple terms, a hedge fund is a fund by a pool of high-income, institutional, or accredited investors, where the portfolio is managed closely by the fund manager.
Yes, a Hedge fund is legal in India. Although it is not regulated strictly by SEBI it is still in its early stages of governance.
Some examples of Hedge funds are Quant First Alternative Investment Trust, Forefront Alternative Investment Trust, Motilal Oswal's offshore hedge fund, Munoth Hedge Fund, India Zen Fund, etc.
A. Generally, the HNIs, UHNIs, pension funds, Institutional investors invest in the hedge funds as it requires high minimum investment.
A. Hedge funds are regulated by the SEBI. But the regulations are less as compared to the regulations on mutual funds.
A. Mutual funds are taxed as per the LTCG & STCG in the hands of investors but hedge funds are taxed at the fund level. The category 3 AIF in India doesn’t have a tax pass-through status in India. Therefore, the taxation for these funds comes out to be around 43%.
A. The cost structure is different in hedge funds as compared to mutual funds. In the case of mutual funds, an expense ratio as fixed by the fund house is applicable on the AUM of the fund. However, in the case of hedge funds, the cost structure includes a fixed management fee which is levied on the total capital invested & a performance fee which is charged on the profits earned on that investment. The fees or expenses come out to be much higher in the case of hedge funds.
A. Hedge funds require a high minimum investment. As per the SEBI rule, the minimum ticket size for hedge funds is Rs.1 crore. But mutual funds generally have a minimum investment amount of Rs.500.
No, a hedge fund is not a bank, it can be called a financial institute but not a bank.
A. Hedge funds are a highly taxable investment. It comes under Category-3 of AIFs and this category doesn’t have any tax-pass-through status in India. It means the tax on gains is taxed at the fund level and there is no obligation on the part of the investor for taxation. The tax rate for the category-3 AIF comes out to be around 43% as per the tax rules.
A. Hedge funds are less liquid as compared to other investment tools or mutual funds. It has a lock-in period that restricts the withdrawals of the investment. The lock-in period of these funds varies from fund to fund.
A. Both types are pooled investment vehicles that invest in market securities based on the investment objective of the fund. Hedge funds invest in different instruments by using complex strategies to generate returns along with hedging the downside or reducing risks by investing in related instruments.
These funds also use leverage for making investments, which makes them riskier compared to mutual funds. The minimum investment requirement is very high in hedge funds which makes them suitable for only high net worth investors. Whereas, mutual funds have very low minimum investment requirements which makes them accessible to every kind of investor.
A. HNIs, UHNIs, insurance companies, financial institutions, pension funds, etc. could consider investing in these funds as they have high minimum investment requirements. An investor who understands the investment strategy and risk associated with investments in hedge funds could consider investments in these funds.
More Information:
Bharat Bond ETF
Post Office Saving Schemes in India
Kisan Vikas Patra Scheme
Senior Citizens Savings Scheme
Mutual Fund Advisor
