KYI: Know Your Investment

What do Hedge Funds do?

Hedge Funds are private investment funds that use complex strategies and investments to generate returns for their investors. They are known for their flexibility in investment styles, leveraging a variety of financial instruments, and often employing risk management techniques to balance potential gains with downside protection.

Why Invest in Hedge Funds?

Investing in Hedge Funds offers the potential for higher returns and risk-adjusted performance, independent of market directions. Hedge Funds can provide portfolio diversification and reduce overall volatility, thanks to their unique strategies and ability to capitalize on short-term market movements.

Hedge funds can be categorized by the complex strategies their fund managers adopt:

  • Long/Short Equity: Involves taking long positions in undervalued stocks while shorting overvalued stocks.
  • Market Neutral: Strives to remove market risk by balancing long and short positions.
  • Global Macro: Focuses on global economic trends and events, investing across various asset classes.
  • Event-Driven: Capitalizes on corporate events like mergers, acquisitions, or bankruptcies.
  • Quantitative: Uses algorithms and quantitative models to identify investment opportunities.
  • Fixed Income Arbitrage: Exploits inefficiencies in fixed income securities.
  • Distressed Securities: Specializes in investing in companies in financial distress.
Particulars Hedge Funds (AIF) Mutual Funds
Regulatory Requirement Regulated under SEBI (Alternative Investment Funds) Regulations, 2021, with less frequent reporting requirements and more lenient disclosure norms. Regulated under the SEBI (Mutual Funds) Regulations, 1996, with daily NAV reporting and strict disclosure requirements.
Investor Profile Target sophisticated investors who can understand and bear the risks associated with such funds. They often require investors to be accredited or institutional, with a higher minimum investment amount. Aimed at the general public, including retail investors. They are accessible with much lower minimum investment amounts.
Investment Strategies May use complex and diverse strategies, including leverage, short selling, and derivatives trading. They have fewer restrictions on the type of investments they can make. Typically use more conservative strategies. They are subject to strict regulatory limits on using leverage and short selling and often focus on long-only strategies.
Liquidity Often have lock-in periods and do not offer daily liquidity. Redemptions are typically processed at specified intervals as per the fund's documentation. Provide daily liquidity and are priced at the daily NAV. Investors can buy and sell units on any business day.
Risk Very High Comparatively Lower
Minimum ticket size 1 Crore Not Uniform, depend on the fund terms but can be as low as 500
Valuation NAV is typically calculated at less frequent intervals, which may be quarterly or as stipulated in the fund documents. NAV is calculated daily, and pricing is transparent.
Minimum Corpus Rs. 20 Crore for a hedge fund Not defined
Fees Often charge a management fee and a performance fee (carried interest), which can be substantial, especially if the fund performs well. Charge management fees, which are generally lower than those of hedge funds, and typically do not include performance fees.
Taxation The tax on Category III AIF is paid by the AIF fund house directly and the investor are not charged seperetely Enjoy specific tax benefits in India, especially equity-oriented funds, which are taxed differently from debt funds.

Learn More

As per SEBI Regulations, Hedge Fund means an AIF which employs diverse or complex trading strategies and invests in securities having diverse risks or complex products including listed and unlisted derivatives.

Hedge Funds are investments which collects capital from institutional and accredited investors, and invests them in domestic and international markets in order to generate high returns that are not corelated with market index returns. Naturally, hedge funds use risky investment strategies, and use a high minimum investment, charging a much higher rate compared to traditional investment funds. 

  • It is imperative to understand that Hedge Funds are only for extremely rich, high-net worth individuals. 
  • Hedge Funds usually charge 2% as the asset management fee and take up 20% of the profits earned as a fee.
  • An investor must invest a minimum of Rs 1 crore in hedge mutual funds, and the fund as a whole must have a minimum corpus of Rs 20 crore. 
  • Unlike mutual funds, hedge funds can take both short/long positions. In the case of Hedge Funds, every investor knows that it is the highest level of risk that they will take. 

As per SEBI, an Accredited investor means any person who is granted a certificate of accreditation by an accreditation agency who, 

  1. In case of an individual, HUF, Family Trust or Sole Proprietorship has:
    • an annual income of at least two crore rupees; or 
    • net worth of at least seven crore fifty lakh rupees, out of which not less than three crores seventy-five lakh rupees is in the form of financial assets; or 
    • an annual income of at least one crore rupees and minimum net worth of five crore rupees, out of which not less than two crore fifty lakh rupees is in the form of financial assets. 
  2. In case of a Body Corporate, has net worth of at least fifty crore rupees; 
  3. In case of a Trust other than family trust, has net worth of at least fifty crore rupees;
  4. In case of a Partnership Firm set up under the Indian Partnership Act, 1932, each partner independently meets the eligibility criteria for accreditation.

Capital from larger investors, including endowments, banks, commercial businesses, pension funds, and HNIs, is combined and invested in hedge mutual funds. They belong under category III of AIFs. This pooled money is used to invest in securities in national and international markets. Hedge funds can invest in a wide range of securities, including derivatives, real estate, convertible securities, currencies, and stocks.

These funds use several, complex trading techniques. Examples of derivatives include futures and options. The trading strategy could include trading on a stock exchange or purchasing it straight from the company through a private placement, similar to how it works with debt and equity instruments. For instance, buying or selling an underlying stock at a predetermined price, date, and time is either an obligation or a right under futures contracts. The same applies to options trading, but there are no obligations. This kind of investing automatically diversifies trading techniques.

  • Domestic Hedge Funds: Open to those investors that are subject to the origin country’s taxation.
  • Offshore Hedge Funds: Fund established outside of your own country, preferably in a low taxation country.

Hedge funds can be categorized by the complex strategies their fund managers adopt: 

  • Event driven: There are few event driven hedge funds that invest to take advantage of price movements generated by corporate events. Distressed asset funds and merger arbitrage funds are two examples.
  • Market neutral: Market-neutral funds aim to minimize market risks. This includes convertible bonds, short and long equity funds, and fixed-income arbitrage.
  • Long/Short selling: By definition, short-selling means that you sell a security without buying it but with the notion of buying it at a predetermined future date and price. On this specified future date, you hope that the share price will decline and you will make money.
  • Arbitrage: An arbitrage strategy involves the simple logic of buying and selling. Through this strategy, fund managers buy security from one market at a lower price and sell the same at a higher price in another market in order to make profit. Relative value arbitrage is used for buying and selling two very highly correlated securities simultaneously and book profits when the market are moving sideways. This is relative value arbitrage. Both securities could be from one, or multiple asset classes.
  • Market-driven: Hedge mutual funds also take advantage of global market trends before they make the decision to invest in securities. They examine world macroeconomic and their potential effects on currencies, equities, interest rates, and commodities.

When one invests in a Hedge Fund, the Fund Manager of a Hedge Fund company then further invests the funds in the securities market. But then how is it different from a mutual fund? The only major difference is the investor profile –from which stems all other differences. Hedge Funds are often called “The Rich Man’s Mutual Fund”. Only the High Net-Worth individuals can invest in a Hedge Fund, whereas anyone can invest in a Mutual Fund. 

  • The minimum investment in a mutual fund is Rs 500, whereas in India, the minimum investment amount is 1 Cr, as per AIF SEBI regulations. 
  • Hedge Funds are covered under SEBI (AIF) category, whereas mutual funds are covered under SEBI (Mutual Fund) Category. 

The Mutual Funds, and Hedge Funds both further invest in the securities market. But the way they invest is different. The strategies used to invest these funds are vastly different. The Hedge Fund Managers invest the Hedge Funds in Derivatives market – Forward, Future, Options, Swaps. They also invest only in short selling stocks – that are the stocks not owned by the fund managers. They borrow the stocks, and when the stock value diminishes, they are returned. It is risky because there are chances of losses too, but Hedge Fund Managers have to adapt aggressive strategies to give high returns. Hedge Fund also used leverage, or borrowed funds as a strategy. By following these strategies, they generate maximum returns for the investors. The returns go to the investors, and the fund managers get a performance fee from the investors. 

The Category III AIF (hedge funds) has not been given a pass-through status on tax. This means that profit-income from Hedge funds will be taxable at the investment fund level. This is a major drawback for this industry when you compare this with other mutual funds. Because of the tax burden, hedge funds have not seen a huge growth.

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