Hedge means to safeguard, in the scope of investment, it means to protect against risks. The funds are collected from insurance firms, high net-worth individuals and families, endowments, pension funds and banks are utilised by hedge funds.
These funds function as private investment partnerships. They do not necessarily have to be registered with SEBI and there is a need to disclose Net Asset Value (NAV) periodically unlike other mutual funds.
The hedge fund portfolios consist of equities, currencies, bonds, convertible securities and derivatives. Due to which they are also considered as alternative investments. Hedge funds require aggressive management because they strive to hedge risks to investor’s money against the ups and downs of the market.
Types of Hedge Funds
There are three types of hedge funds:
- Domestic Hedge Funds - They are open to only those investors who are subject to the taxation of the origin country.
- Offshore Hedge Funds - These are established outside of the country of origin (investor’s country). They are generally established in countries with lower tax slabs.
- Fund of Funds - These are mutual funds that invest in other hedge mutual funds rather than investing in individual securities.
Features and Benefits of Hedge Funds
The hedge fund industry in India came into being in 2012 when SEBI gave a green flag to alternative investments funds (AIF). The features of hedge funds are listed below.
- Hedge funds receive investments from only qualified or accredited investors. The investors include banks, high net worth individuals, endowments, insurance companies and pension funds. Rs. 1 crore is the minimum ticket size for investing in hedge funds.
- These funds offer a diverse range of portfolios to choose from and they necessarily cover all the asset classes that are limited by the mandate.
- The concepts of expense ratio and management fee are employed in the working of hedge funds. In the Indian context, the management fee may fall below 2% to below 1%, while the profit sharing swings between 10% to 15%.
- Hedge funds are categorised by greater risk of losses. They expose investments to huge losses. The lock-in period for hedge funds is longer and the leverage used by the funds has the potential of turning the investments into losses.
- Income from hedge funds is taxable at the investment fund level. This is also viewed as a disadvantage as they are not at a level playing field to other mutual funds.
Different Strategies of Hedge Fund Investing
Hedge funds are also categorised on the basis of the strategy adopted by fund managers to maintain their funds.
- Event Driven - A few hedge funds are driven by the motive of taking advantage of the price movements generated by the corporate events. Distressed asset funds and merger arbitrage funds are examples of event driven hedge funds.
- Market Neutral - These are the funds that aim to minimise the market risks. Short and long equity funds, fixed income arbitrage and convertible bonds are the examples of market neutral hedge funds.
- Arbitrage - According to this strategy, a security is bought from the market where it is trading at a lower price and it is then sold in some other market where it is running at a higher price. It also has a variation, the relative value arbitrage, and it involves two securities. The two securities, that are highly correlated, are bought and sold in order to book profits when the markets are moving sideways. The securities can be from one or multiple asset classes.
- Short Selling - The security is sold without the actual purchase but with a notion of buying it at a price and date in future that is predetermined. The share price is hoped to drop on this date and then the profits can be booked.
- Market Driven - This involves analysing the global market trend before making a decision with respect to investment of securities. Studying the global macros gives a glimpse of the impact on interest rates, currencies, commodities and equities.
It can be concluded that Hedge Funds are quite complex in their structure and the strategies employed for their investment. They are highly diversified as they cover almost all classes of assets. It must be noted that hedge funds need not be registered with the market regulator nor do they have reporting requirements like disclosure of NAV.