Hedge Funds - Meaning, Features, How are They Different from Mutual Funds

Gaurav Seth
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Gaurav Seth

Know About Hedge Funds

Hedge funds are one of the alternative investment avenues that pools money from accredited investors like HNIs, UHNIs, institutional investors, pension funds, banks & insurance companies, etc. to invest in various securities in the market for generating returns. They deploy complex investment strategies for the purposes of investment-related decision making. As the name implies "hedge", these funds aim to protect downsides or reduce risks through their exposures in related instruments available in the market. 

Hedge funds are quite popular in developed markets like the US, UK, etc. In India, the hedge market is fairly small & young as they were introduced under the regulations of SEBI in 2012 as "Alternative Investment Funds". As per SEBI AIF classification, hedge funds in India come under the Category-3 of AIFs. Category-3 AIFs include alternative investments such as hedge funds, PIPE Funds etc. which deploys compex trading strategies along with using leverages to invest in listed or unlisted securities for generating returns on investments. As per the latest data available, the Indian hedge fund industry has approx. Rs.35,777 crores of total investments.

The Category-3 AIF investments have seen a slow growth in their assets in the last few years because of the exorbitant taxes levied on them by the government. Further incentives & relaxations of tax rates by the Indian Government would be needed for the growth of this industry.

Features of hedge funds

What is Hedge Funds

Type of Investors: Investments in hedge funds are made by the affluent class of investors owing to its high ticket sizes. Generally, High Net-Worth Investors(HNIs), UHNIs, Insurance companies, Banks, & Pension funds make investments in hedge funds.

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.

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 own 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.

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 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.

And the risks can even be higher than the other investments because they can take leverage up to 2x of their total assets which increases the risks.

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Returns: The returns from hedge funds can be higher than that of the other investment options because of their deployment of 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 have been able to deliver positive & good returns despite the gloomy market conditions. 

Their strategies are deployed in a way that they could benefit from the high volatilities arising in the markets.

Fees or Costs: Globally, the hedge funds industry has a fee structure of "2 and 20 annually" where 2% is the fixed management fees of the investor's assets. And 20% is the performance fees, which means if the fund is able to 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.

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%.

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 less liquidity to the investors as compared to other investment options like mutual funds, stocks where they can sell anytime as per their will.

Regulations: The category-3 AIF along with the other AIFs comes under the regulations of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012. 

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About regulations & transparency, the hedge funds are not as transparent as other investment products. Also, they do not have strict regulation requirements like others.

Recently in February, SEBI has issued mandatory guidelines for the Cat-3 AIFs relating to disclosure mechanism wherein the hedge funds would have to mandatorily conduct performance benchmarking on a half-yearly basis. This move is expected to improve transparency for investors as they would be able to see the returns or alpha generated by the funds compared to their benchmarks. Previously, there wasn't any benchmarking which made a comparison among funds difficult.

How Hedge Funds Work ?

Investment Strategies adopted by hedge funds

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.

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.

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 on the basis of 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 in the near future.

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.

Relative Value Strategies: These strategies involve 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 same issuer).

Short Only:  This strategy involves going short on the securities which are overvalued or are expected to fall in the near future 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.

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.

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.

Hedge Funds vs Mutual Funds

HeadHedge FundsMutual Funds
1. Type of Investors

HNIs, UHNIs, Insurance Companies, Banks, Pension Funds, etc.

Few Investors.

Preferable by Retail Investors, others also invest.

A large number of investors.

2. CostsGenerally, Fixed fees on Assets and Performance fees on profits.Fees only on AUM.

Minimum Investment- 1 crore

Promoter also needs to contribute 5% or 10 crores whichever is less.

Minimum Investment- Rs.100

No requirement of contributions by the promoters.

4. Risk-Returns

Risk- Depends upon strategy but they aim to reduce risks through hedging.

Use Leverage, therefore higher risks.

Returns- Higher potential returns than mutual funds.

Risk- Depends upon the type of fund, their underlying assets, & strategies.

Do not use leverage.

Returns- Returns depend upon markets.

5. CorrelationAim to make investments with low correlation to the markets.

High correlation with the markets.

If the market falls, MF’s Nav will also fall.

6. Taxation43% Tax at the fund level. No passing of tax obligation to investors. 

Different taxation for debt & equity MFs. 

Lower tax than hedge funds.

7. RegulationsLow Regulations & Transparency.High Regulations & Transparency.

Who can invest in hedge funds ?

Investments in hedge funds are suitable for wealthy or high net-worth investors because of its high investment requirements, as mentioned earlier. As the hedge funds deploy complex investment strategies to generate returns, it is very important for the investors to understand the risks associated with their capital. 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 while choosing between different hedge funds for investments as not all funds in India or across the globe are able to generate positive or efficient returns for the investors.

Hedge funds in India

Some of the hedge funds(or Category-3 AIFs) operating in India are:

  1. Avendus Equity Returns Fund- 2
  2. Edelweiss Alpha Fund - Scheme 1
  3. DSP India Enhanced Equity SatCore Fund
  4. Alchemy Leaders of Tomorrow
  5. ITI Long Short Equity Fund
  6. Nippon India- The NEXT BILLION
  7. Old Bridge AIF
  8. True Beacon

Frequently Asked Questions (FAQs)

Q. What are hedge funds?

A. Hedge funds are an alternative investment vehicle that invests in different securities in the market. These funds make investment strategies to get the downside protection or reduce the risk along with generating high returns on the investment.

Q. How are hedge funds taxed?

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.

Q. How are hedge funds different from mutual funds?

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. 

Q. Who should invest in hedge funds?

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.

Q. Do hedge funds have a lock-in period?

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.

Q. What are the different strategies of hedge funds?

A. Hedge funds use complex strategies to hedge their downside risks and generate high returns for investors. Different strategies used by hedge funds are:

  1. Long-Short
  2. Global Macro
  3. Event-driven
  4. Fixed Income Arbitrage
  5. Relative value strategies
  6. Short only
  7. Quantitative
  8. Multi-Strategy

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