Hedge Fund is an investment fund, formed by pooled capital of accredited investors, both individual and institutional. The pooled funds can be invested in a wide range of stocks, securities, real estate and, derivatives.
If we study the name, Hedge basically means ‘to avoid,’ and here in the case of mutual funds, it means to avoid risk. Such funds operate as an overseas investment alternative or private investment partnership. It is so because the funds here are collected from sources like insurance firms, banks, individuals or families with high net-worth and even pension funds. Unlike any other mutual funds, hedge funds are under no obligation to be registered under SEBI or declare their Net Asset Value (NAV) periodically.
Who should invest?
Hedge funds are generally managed and operated by professionals. Due to this reason, the fee and other charges tend to lie on the expensive side. Therefore, only investors that can afford to bear the expenses must indulge in hedge funds. There can be times when the expense ratio might go up to even 20% of the total returns. Along with it, hedge funds are a lot riskier since the buying and selling happens at lightning speed. One must be an aggressive risk seeker to be able to make the most of this fund. With the high risk and even higher cost, it is adviced for regular investors only. The first-timers must steer clear of it until they gain sufficient knowledge.
Features of Hedge Funds:
Hedge funds are a relatively new investment alternative in India, and many people do not have full knowledge about it. Let’s understand thoroughly what hedge funds are.
As we said only individuals with high net worth could invest in a hedge fund. The minimum ticket size of investment is Rs 1 crore, hence only rich and accredited investors can invest in it.
Hedge funds provide a whole gamut of options to choose from. An investor can make a widely different portfolio while choosing from shares, stocks, currencies, derivatives, etc. they cover all the options possible to be included in the portfolio.
As mentioned earlier, hedge funds are a little costlier since it involves too many expenses. There is a management fee too, along with the expenses. In India, the management fee normally is 1% or 2%, whereas the ratio of profit sharing can go up to 15%, but it is usually settled around 10%.
Hedge funds are under the Category III AIF, and are not exempted from taxes. The income from hedge funds is taxable at the level of an investment fund. It implies that it will be taxable not in the hand of the investor or the unit-holder.
Under hedge funds, the lock-in period is generally longer than the other types of funds. With the huge amount of investment involved, the chances of losses go even higher. Leverage used by the fund manager may turn it into huge losses. Therefore, these funds have a lot of risks involved.
It is not mandatory for a hedge fund to be registered with the apex institution SEBI. There is no further restriction of periodically disclosing the Net Assets Value of the fund, making it hassle-free and convenient.
How does it work?
The success and earnings of a hedge fund depend entirely upon the capability of the fund manager. It is on him, to use his skills to derive profits. His primary motive is to reduce or completely remove the risk caused by market changes. There are many strategies that a fund manager use to push the profits. They can be:
- Using arbitrage: There can be times when the prices of securities are inaccurate or inefficient. A manager can use it to their advantage.
- Investing closer to a market event: A fund manager has sufficient knowledge about the market, and they know about the happening of big events like mergers and acquisitions. Taking a quick action closer to this can be beneficial for the investors.
- Sell short: In this case, the fund managers wait till the time the prices drop, to reap in the profits during buy-back of shares.
- Investing in discounted securities: This is yet another trick used by the fund manager. There are a few times when the prices of stocks take an unbelievable dip because the company is under distress. Here, the managers take advantage by investing in it at lower prices, only after weighing all the consequences.
Difference between mutual funds and hedge funds
Although they seem to be quite similar, in reality, there are a few differences. Hedge funds involve much more risk, making mutual funds a safe alternative. Apart from that, mutual funds are less aggressive than hedge funds. In hedge funds speculation position is used and even short selling of securities is done, which is never done in the case of mutual funds. Lastly, mutual funds have more accessibility. The investors from all categories can invest in mutual funds since they can start with SIP of as low as Rs 500. But in the case of hedge funds, it is only open for rich investors as the minimum investment is of Rs 1 crore, which only people with high net worth can afford.
Hedge funds are a relatively new mode of investment in India. It started only in the year 2012 when it was allowed by SEBI as an alternative investment fund. The primary aim is to achieve high returns, but it comes with even higher risk of losses. It is a highly dynamic investment alternative, with prices fluctuating frequently. On top of it, the amount of investment being higher creates much more pressure. Since the fund manager entirely manages the hedge fund, it is essential to be sure of his capabilities.