What are Hedge Funds and Should You Invest in Them?
The word hedge means to protect your investment from unwanted risks and dangers. Hedge funds are mutual funds where a seasoned fund manager pools money from several High-Net-Worth investors and put that to use for hedging risks and generating returns.
The fund managers adopt diverse, complex strategies like trading non-conventional assets, leveraging and arbitraging to potentially generate lucrative returns. Unlike other funds, hedge funds are not mandated to register themselves with the Securities and Exchange Board of India (SEBI). Nor do these funds need to disclose their net asset value at regular intervals.
This blog explains how do hedge funds work, their types and features, strategies used, taxation, limitations and if you should invest in hedge funds. Read on!
How Do Hedge Funds Work?
Several entities pool their money in a hedge fund mutual fund scheme. This makes them partners in that investment, and such funds will function as an LLP (Limited Liability Partnership) or LLC (Limited Liability Companies). As the name suggests, the liability of partners, as well as fund managers, remains limited.
The minimum investment to participate in a hedge fund is Rs.1 crore. Moreover, a maximum of 1000 investors can take part in one hedge mutual fund scheme. As per SEBI regulations, a scheme must generate a minimum pool of Rs.20 crores to start functioning.
Fund managers invest the amount in certain non-traditional assets or use hedging techniques to seek market-beating returns. Fund managers tend to operate in small market segments with a high degree of diversification.
What Are the Types of Hedge Funds?
Here are the different types of hedge funds that are currently operating in the market:
• Global macro hedge funds:
These funds are active hedge funds in which managers try to take advantage of changes occurring in global markets due to political and economic factors.
• Equity hedge funds:
These funds invest in various equity instruments at a national or international stage. Under this, they invest in either lucrative stocks or take advantage of downturns by shorting undervalued equity instruments.
• Relative value hedge funds:
These funds seek to earn profit by taking advantage of the price differential of related securities and spread inefficiencies.
• Activist hedge funds:
Fund managers invest money in companies whose actions stimulate the stock price. These involve demands to reduce costs, change occurring in the company’s board and restructuring of assets.
What Are the Features of Hedge Funds?
In India, hedge funds function as Alternative Investment Funds (AIF). Here’s a list of features:
• Large Investors
As the risk associated with these funds is quite high, only large high-net-worth investors are eligible to invest in this fund. Insurance companies, pension funds, endowments and sovereign wealth funds can put their money in this mutual fund scheme. Since minimum investment is quite high in these schemes, entities with a heavy purse can afford them.
• Diversification
These funds are one of the most diversified mutual funds in operation. It invests the corpus in various instruments like stocks, derivatives, real estate, currencies, and even cryptocurrencies. The goal is to incorporate all asset classes, which can serve as a hedge against other market fluctuations.
• Regulations
As these are relatively newer versions of mutual funds, it is not stringently regulated. Hedge fund houses do not need to register with the Securities and Exchange Board of India. Moreover, like other mutual fund schemes, they do not require to disclose their NAV regularly.
• High Risk
Due to the complex strategies and unconventional assets that hedge funds deal with, they come with a high degree of risk. The lock-in period of these investments is uncharacteristically long, and a change in market conditions can bring significant losses.
Also Read
What Are Hedge Fund Strategies?
You can follow these strategies while dealing with hedge funds to earn significant returns:
• Global Macro Strategies
When dealing with hedge funds, it is ideal to focus on global macroeconomic trends like interest rates, demographics, and economic and political trends. Moreover, one should have knowledge about various financial markets and trading related to currencies, futures and options.
• Event-oriented Hedge Fund Strategy
As the name suggests, these funds tend to rely on certain events and focus on opportunities and risks arising from the same. These events are corporate transactions like mergers, acquisitions, recapitalisation or liquidation. Managers consider these events thoroughly and invest in related securities accordingly.
• Directional Hedge Funds Strategy
In these funds, managers closely follow the directions of the market and analyse whether the trend will continue or whether there are chances of reversal in them. After analysing the trends, managers invest in long or short emerging market funds or long and short hedge funds.
• Long or Short Strategies
Under this strategy, managers undertake a pair trade. A pair trade is one in which you invest in two securities from the same sector.
For example, as per market analysis and recent performance, you believe that BPCL will perform better than Indian Oil Corporation. In such a scenario, you will short-sell IOC security and go long on BPCL. Regardless of the overall market trend, you will be in a better position till BPCL outperforms Indian Oil Corporation.
Who Should Invest in Hedge Funds?
A hedge fund is an unconventional mutual fund scheme that adopts a hedging strategy to offer significant returns to its investors. As per SEBI’s guidelines, one can invest in a hedge fund with a minimum investment of Rs.1 crore. Also, the total value of the fund needs to be a minimum of Rs.20 crore. These guidelines make hedge funds ideal for investors who have a huge investment corpus, especially institutional investors.
Moreover, the risk associated with these funds is quite high. Therefore, it is suitable for entities having a high-risk tolerance level. Aggressive investors looking for market-beating returns but are also ready to take risks can think about investing in these funds.
What Are the Risks or Limitations of Hedge Funds?
Here are some risks that one has to deal with when they invest in hedge funds:
- These funds opt for a concentrated strategy which puts the investments at huge risk of significant losses.
- Due to the low demand for these funds, these funds have the lowest liquidity among all mutual funds in operation. Low liquidity will make it difficult for you to exit this scheme in case of a financial emergency.
- Investors must go for a particular lock-in period while investing in these funds. This means that for a said number of years, you cannot withdraw your money, and any emergency withdrawal will come at hefty penalties and charges.
- Leveraging in hedge mutual funds can transform a minor loss into a major one in case of a market downturn.
How Are Hedge Funds Taxed?
Unlike other mutual funds in India, hedge funds or alternative investment funds do not comply with the usual rules of taxation. All income or gains arising from these funds shall be taxable at the fund level rather than on the part of the investors. This means that investors do not have to pay any tax, and all taxes shall be payable by fund houses under applicable provisions.
This irregular playing field for hedge funds, as compared to other mutual fund categories, has acted as a major roadblock to the development of the hedge funds industry.
Difference Between Mutual Funds and Hedge Funds
Although hedge funds are a subcategory of mutual funds, there are significant differences between the two of them, which have been discussed below:
| Parameter | Hedge Funds | Mutual Funds |
| Investment Approach | These funds represent an aggressive brand of mutual fund category. Investors generally seek higher returns on their investments, and therefore hedge funds adopt an aggressive investment approach. | Mutual funds can be aggressive or conservative depending on the type of fund. An equity fund will be more aggressive as compared to a debt fund. |
| Leverage | Risk is higher in them as they carry greater leverage. | Mutual funds are relatively safer as they do not deal with heavy leverage. |
| Investor Type | Only sophisticated and high-net-worth individuals can invest in them as the minimum investment amount is set as Rs. 1 crore. | All categories of investors, whether small retail investors or large institutional investors, can put their money in mutual funds. |
Things to Consider Before Investing in Hedge Funds
Here are some things that you should consider before investing in hedge funds:
1. Investment Objective
Every individual who undertakes an investment has some objectives in his/her mind that he/she seeks to fulfil. As these funds come with a lock-in period, it is more suitable for fulfilling long-term financial objectives. Therefore, you should analyse your financial goals and see whether they are in sync with the fund’s objectives before investing in them.
2. Risk Appetite
A hedge fund comes with a high degree of risk. It has great return potential, but there are chances of incurring significant losses as well. In light of these, a hedge fund can be an ideal investment for aggressive investors only. On the other hand, conservative investors may not prefer investing in them.
3. Manager’s Past Performance
Another important thing that you should consider while investing in these funds is the past performance of the respective fund manager. As all decisions taken by him/her will determine the profitability of the fund, it is imperative for investors to analyse their past performance and see whether they have been able to produce desired results.
Final Word
Hedge funds are a type of mutual fund which focuses on non-traditional investment methodologies and complex strategies to generate significant returns. Due to the nature of these funds, they could be an ideal investment alternative for large institutional investors like pension funds, endowments, etc.
However, hedge funds are considered to be more aggressive and riskier as fund managers tend to use a concentrated investment strategy that can lead to huge losses. Hence, investors should do thorough market research before going ahead with any investment decision.
If you do not have Rs.1 Crore to invest in a hedge fund, don’t worry. With Navi Mutual Fund, you can invest in mutual funds with SIPs starting at just Rs.500 per month. Download the Navi App and start investing now!
Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
FAQs
Ans: New units of an open-ended hedge fund are issued regularly for subscription. Moreover, it also allows regular withdrawals based on the net asset value of each unit of the mutual fund. Hence, open-ended funds are considered to be highly liquid in nature.
Ans: As per regulations of the Securities and Exchange Board of India (SEBI), accredited and institutional investors can put their money in these funds. These include high-net-worth individuals, pension funds, sovereign wealth funds and investment banks among others. The minimum investment for each investor for these funds is Rs.1 crore.
Ans: Hedge funds are a lot riskier than mutual funds. It can wipe out all gains and even the invested capital in case of turbulence or downturns in markets. On the other hand, the returns generated can be exponential if the fund manager applies effective tactics. Due to such high risks, you should invest in them only after conducting thorough market research.
Ans: Hedge fund asset management companies charge a particular fee from investors based on their assets under management. It can be a flat charge expressed in absolute value or percentage value and varies from one fund house to another. This fee is referred to as the expense ratio.
Want to put your savings into action and kick-start your investment journey 💸 But don’t have time to do research? Invest now with Navi Nifty 50 Index Fund, sit back, and earn from the top 50 companies. Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully. This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
