What are Hedge Funds & How are they Regulated?
A hedge fund pools money from private investors and is managed by professional fund managers. These managers use various strategies, such as leverage (borrowed money) and trading non-traditional assets, to seek higher-than-average returns. Investing in hedge funds is often seen as risky and requires a high minimum investment or net worth, making them typically accessible to wealthy investors.
What is a Hedge Fund in India?
Hedge funds pool capital from accredited high-net-worth individuals and institutional investors to generate high returns by investing in diverse assets and using various strategies. This approach aims to minimise risk and maximise investor value.
In India, the Securities and Exchange Board of India (SEBI) introduced hedge funds in 2012 under the SEBI (Alternative Investment Funds) Regulations. They are classified as category III alternative investment funds and are still in their early stages, needing further regulation.
Typically structured as limited partnerships, hedge funds are managed by professional fund managers. Unlike mutual funds, which face strict SEBI regulations and investment restrictions, hedge funds operate with greater flexibility in their strategies.
History of Hedge Funds
The hedge fund industry began in 1949 when Alfred Winslow Jones launched an equity fund organised as a general partnership. This structure allowed him to construct a flexible portfolio by taking both long and short positions in securities, aiming to boost returns and reduce net market exposure. Jones also used leverage to enhance performance.
In the mid-1950s, other incentive-based partnerships emerged, including Warren Buffett’s Buffett Partners and Walter Schloss’s WJS Partners. These funds, influenced by Benjamin Graham’s long-biased Graham-Newman partnership, did not primarily focus on shorting shares to hedge market risk. However, they would be considered hedge funds under today’s broader definition. Nowadays, a “hedge fund” encompasses many funds exposed to different risks.
How Do Hedge Funds Work?
Hedge funds use various trading techniques to invest in securities and assets, including derivatives like futures and options traded on stock exchanges. Derivatives get their name because their value depends on an underlying asset. Hedge funds often employ leverage, borrowing money to invest in securities, and they engage in short-selling, profiting from declining stock prices. These strategies can yield high returns but have higher risks than traditional investments.
Examples of derivatives include futures and options (F&O). These can be traded in the stock market or bought directly from the hedge company. For instance, futures grant the right or obligation to buy or sell an underlying stock at a predetermined price, date, and time. On the other hand, options provide similar trading opportunities without mandatory commitment, which is how hedge funds work. Investing in these securities inherently introduces diversification in hedge fund trading techniques.
Simply put, many hedge funds—‘hedge funds’—hedge their bets by taking offsetting positions to minimise risks. This means buying put options, selling short, or buying that could outperform the market at different times. They can thus minimise their losses to some extent if the assets they hold fall in value.
What are the Key Characteristics of Hedge Funds?
Here are some of the characteristics of the best hedge funds in India.
- Qualification: Typically only available to accredited investors who meet certain minimum income or net worth requirements. The minimum pooled money required to start a hedge fund is Rs.20 crore. This is because they are considered to be risky investments. Regulators want to ensure that investors have the financial resources to withstand potential losses.
- High Fees: A hedge fund company typically charges high fees, including management and performance fees. Management fees are typically a percentage of the fund’s assets, while performance fees are typically a percentage of the fund’s profits.
- Lock-in Period: Typically, there is a lock-in period when investors cannot withdraw their hedge money. This lock-in period can range from several months to several years.
- Strategy: Hedge funds use a variety of investment strategies, but they all share the goal of generating high returns. Common strategies include long/short equity, event-driven, and macro.
Types of Hedge Funds
Here are the four main types of hedge funds:
- Global Macro Hedge Funds: These funds profit from market fluctuations by leveraging macroeconomic factors like inflation rates and other financial conditions.
- Relative Value Hedge Funds: These funds capitalise on the price differences between related securities to generate higher returns.
- Activist Hedge Funds: These funds invest in companies that make significant changes, such as cost-cutting or asset restructuring, in response to diverse demands.
- Equity Hedge Funds: These funds invest in global or domestic stocks and protect against market downturns by selling overvalued stocks or stock indices.
What are the Different Strategies of Hedge Fund Investing?
The top strategies of hedge investing that hedge fund managers and hedge fund companies in India follow are:
- Long or Short Equity: A short or long equity hedge fund strategy seeks to generate returns by taking long and short positions in individual stocks.
- Global Macro: The global macro strategy uses macroeconomic factors. To invest in various assets, such as interest rates and currency exchange rates.
- Event-driven: Investments are made in companies undergoing significant corporate events, such as mergers, acquisitions, and bankruptcy.
- Quantitative: This strategy uses mathematical models and algorithms to identify investment opportunities.
How are Hedge Mutual Funds Taxed?
Category III Alternative Investment Funds (AIFs) are taxed based on rules specific to this category. Unlike pass-through vehicles, these funds must pay taxes on gains or income at the fund level, meaning the tax responsibility does not pass to the investors. Hedge funds falling under this category face this tax directly, which can deter their growth in India due to the high tax burden. Taxes are deducted before profits are distributed to investors, reducing the net returns for domestic investors.
| Income | Tax Rate |
|---|---|
| Annual earnings exceeding Rs 5 crores | 42.74% |
| Annual earnings below Rs 5 crores | 30% |
| Dividends | 15% |
What is the Hedge Fund Structure & Fees?
Hedge funds employ a standard “2 and 20” fee system today. The fee structure comprises two components: a management fee typically below 2% and a performance fee of 20%. Therefore, to invest in hedge mutual funds, the minimum investment fund required is ₹1 crore per investor, while the entire fund must have a minimum corpus of ₹20 crore.
What are the Risks and Returns in Hedge Funds?
The relaxation of regulatory requirements highlights the high risk associated with this product. Hedge funds invest in high-risk securities and are not legally required to register with SEBI or disclose their NAV.
While other funds are closely regulated, these lack the same legal oversight, increasing their risk. SEBI doesn’t ignore these funds, but the absence of strict regulations elevates their risk profile.
Risk and return are directly proportional, and hedge funds are no exception. Their returns are often high, with average annual returns reaching up to 15%, thanks to the expertise of hedge fund managers.
What is the Example of Hedge Funds?
Imagine XYZ Hedge Fund, a well-known hedge fund with expertise in the technology sector, identifies ABC Company as a promising investment opportunity.
To capitalise on this opportunity, XYZ Hedge Fund decided to take a long position in ABC Company’s stock and purchase a substantial number of shares at the current market price.
Furthermore, XYZ Hedge Fund employs a hedging strategy to manage risks associated with their investment in ABC Company. They may choose to implement derivative contracts, such as options or futures, to protect against potential downside risks or volatility in the market.
Over time, as ABC Company’s stock price increased, XYZ Hedge Fund realised gains on their investment.
It’s important to note that this hedge fund example is a hypothetical scenario to illustrate how a hedge fund could potentially invest in ABC Company. Actual investment decisions made by hedge funds are based on numerous factors, including market conditions, fund strategies, risk management techniques, and individual fund mandates.
Who Should Invest in Hedge Funds?
Hedge funds cater to high-net-worth individuals, institutional investors, banks, insurance companies, and pension funds. These investors have substantial capital and access to expert advice.
Investing in hedge funds requires a minimum of ₹1 crore, making them mostly inaccessible to the general public. These funds carry high risk and are subject to significant taxes.
Hedge fund strategies suit affluent investors with surplus funds who can handle additional risk for the potential of higher returns. Potential investors should also consider these investments’ high costs and fund-manager risk.
What are the Things to Remember Before Investing in Hedge Funds in India?
We have listed some of the factors to consider while investing in hedge mutual funds in India.
- Read the Hedge Fund’s Documents and Agreements: Carefully read the documents as they contain the fund’s strategies, the location of the fund, and the risks anticipated by the investment.
- Understand the Risk: Since hedge funds in India are highly volatile, you should consider all the risks involved as a hedge fund investor.
- Expensive: Since the minimum ticket size is ₹1 crore, which is slightly high for an average investor, be considerate before putting in this amount.
- High Fees: These fees can reduce your hedge fund’s returns, so it is important to understand them before you invest.
What is the Difference Between Hedge Funds and Other AIFs?
While multiple Alternate Investment Funds(AIFs) share some similarities, such as accepting investors’ money and investing it collectively, they also have unique characteristics that set them apart from hedge funds.
Let’s have a look at the following table:
| Feature | Hedge Fund | Mutual Fund | Venture Capital | Private Equity | Commodity Pool |
| Investment Objective | Generate absolute returns, regardless of market direction | Generate moderate returns over the long term | Provide capital for early-stage companies with high growth potential | Acquire and manage private companies | Invest in commodities |
| Investment Strategies | A diverse range of strategies to seek high returns and mitigate risks. | Invest in a diversified portfolio of stocks, bonds, and other assets | Invest in early-stage companies through seed rounds, venture rounds, and later-stage rounds | Invest in private companies to provide capital for expansion or buyouts. | Invest in commodity futures contracts to gain exposure to commodity markets. |
| Risk Tolerance | High | Moderate | High | High | High |
| Liquidity | Illiquid | Liquid | Illiquid | Illiquid | Illiquid |
| Fees | High | Low | High | High | High |
| Regulation | Less regulated | More regulated | Less regulated | Less regulated | Less regulated |
| Investors | Accredited investors | Retail investors | Accredited investors | Accredited investors | Accredited investors |
To Wrap It Up…
To conclude, the structure of hedge fund companies in India is complex. Thus, these funds, even executed by the top hedge fund companies in India, are often regarded as the risky alternative investment choice. On the other hand, it provides an opportunity for premium hedge fund investors to gain attractive returns over time. Therefore, investing in these financial instruments is advisable only if your risk tolerance aligns with your goal.
Frequently Asked Questions on Hedge Funds
Hedge fund strategies encompass investments in debt, equity securities, commodities, currencies, derivatives, and real estate. These funds, which are lightly regulated by the SEC, generate income through a 2% management fee and a 20% performance fee.
A wealthy individual who can afford to invest in a hedge fund may be drawn to the manager’s reputation, the specific assets the fund has invested, or its unique strategy.
Hedge funds and mutual funds are both pooled investment vehicles but differ in strategies, fees, investor qualifications, and liquidity. Hedge funds use diverse, actively managed strategies with higher fees and often require accredited investors. While mutual funds offer simpler strategies of hedge funds, lower fees, and greater liquidity to a broader investor base.
To invest in hedge funds in India, you must meet the eligibility criteria as an accredited investor. Search for SEBI-registered hedge funds, consult financial advisors, and complete the necessary documentation.
Hedge fund examples include Motilal Oswal’s offshore hedge fund, Munoth Hedge Fund, Quant First Alternative Investment Trust, IIFL Opportunities Fund, and India Zen Fund.
Karthik Sarma is an Indian hedge fund billionaire. As of June 2023, his net worth was estimated at US$2.9 billion. Sarma earned a bachelor’s degree from the Indian Institute of Technology Madras and a master’s from Princeton University.
To start a hedge fund in India, you need to:
1. Register as an investment manager with SEBI
2. Raise a minimum corpus of Rs.20 crore from accredited investors
3. Hire a team of experienced investment professionals
4. Develop and implement a hedge fund investment strategy
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