What are Hedge Funds & How are they Regulated?
Hedge funds are a unique and intriguing segment of the investment world. As private investment limited partnerships, hedge mutual funds are a type of mutual fund that is funded by high-net-worth individuals, institutional investors, and accredited investors. Confused?
Well, this product is a bit complex.
With a history rooted in the mid-20th century, when Alfred Winslow Jones created the first hedge funds strategy. This has evolved into sophisticated entities that can influence financial markets and challenge conventional investment wisdom. In this blog, we will delve into the world of hedge finance, and explore hedge fund companies, strategies, impact, and benefits and drawbacks it offers to investors.
What is a Hedge Fund in India?
A hedge fund India (h funds) is a private investment or a limited partnership fund of only selected investors. These types of mutual funds are regulated by a hedge fund manager in India. Thus, the manager applies the best hedge fund strategies, including leveraging non-traditional assets to earn above-average returns. Introduced in the 1950s, hedge funds may also refer to unregistered investment pools like venture capital funds, private equity funds, and commodity pools.
While larger hedge funds are regulated by the SEC like mutual funds and ETFs. However, smaller hedge funds and those that qualify as private equity advisors. The Securities and Exchange Board of India (SEBI) introduced hedge funds in India list as part of the SEBI Alternative Investment Funds Regulations in 2012.
SEBI register derives the hedge fund meaning as:
The hedge fund in India, including the fund of funds, is an unregistered private investment partnership, fund or pooled investment that invests and trades in a wide variety of markets, strategies, and instruments (such as securities and non-securities). It is NOT subject to the same regulatory requirements as mutual funds, including the requirement that mutual funds provide investors with periodic and standardized pricing and valuation information.
History of Hedge Funds
The history of hedge funds dates back to 1952 when Alfred Winslow Jones created the first hedge fund strategy. He aimed to mitigate the two risks: market performance and individual asset performance. His approach involved investing in stocks expected to outperform the market. While short-selling assets anticipated to decrease in value, thus creating a ‘hedge’ against market movements. This innovative strategy became the prototype for hedge funds, offered as a limited partnership with a 20% fee.
In 1969, fund managers introduced fund-of-funds to cater to investor interest. After a setback following the 1973-74 market crash, it resurged in the 1980s and boomed in the 1990s, launching dominant hedge funds. They entered the mainstream in the 2000s, with pension funds and insurance companies making their initial investments. Following the 2008 financial crisis, it faced increased regulation. Today, private equity and hedge funds globally manage assets worth approximately $3 trillion.
How Do Hedge Funds Work?
Indian Hedge funds are sometimes called ‘rich man’s mutual funds’. The hedge fund companies in India use different trading techniques because of the multiple assets and securities they invest in.
Hedge funds invest in (and/or short) publicly traded stocks, but they can also make money by investing in alternative assets, such as fine art, real estate, currencies, crypto, and even patents.
Examples of derivatives include futures and options (F&O). These can be traded in the stock market or can be 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. Investing in these securities inherently introduces diversification in trading techniques.
To simply put, many hedge funds – ‘hedgex fund’ their bets by taking offsetting positions to minimize risks. Meaning buying put options, selling short, or buying that could outperform the market at different times.
They can thus minimize 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 fees and performance fees. Management fees are typically a percentage of the fund’s assets. However, the performance fees are typically a percentage of the fund’s profits.
- Lock-in Period: Typically have a lock-in period, during which time investors cannot withdraw their hedge money. This lock-in period can range from several months to several years.
- Strategy: Use a variety of investment strategies, but they all share the goal of generating high returns. Common hedge fund strategies include long/short equity, event-driven, and macro.
What are the Types of Hedge Funds?
The three main hedge fund types are:
- Offshore: Located in countries with less tax environments. So that any hedge fund investor can access them, regardless of their home country.
- Domestic: Limited to investors who are subject to taxation within the same country as the fund’s location.
- Fund of Funds: Operates as a mutual fund that directs investments into a diversified portfolio of multiple hedge funds.
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. Such as interest rates and currency exchange rates, to invest in various assets.
- Event-driven: Investments are made in companies undergoing significant corporate events, such as mergers, acquisitions, and bankruptcy.
- Quantitative: This strategy involves using mathematical models and algorithms to identify investment opportunities.
How are Hedge Mutual Funds Taxed?
Currently, these funds belong to Category III AIF (Alternative Investment Fund). These are subjected to taxation based on the rules applicable to this category. It’s important to note that Category III AIFs are not currently treated as pass-through vehicles for tax purposes.
This means that the fund whole has to pay whenever it has gained or received income in any form.
Here is a table summarizing the tax treatment of these mutual funds in India:
| 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?
Today, hedge funds employ a standard “2 and 20” fee system. The fee structure for these funds 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 above-mentioned points mentioned in the hedge fund structure and fees section speaks volume of its high-volatile nature.
Apart from the fact that the underlying securities that the top hedge funds in India invest in carry a high degree of risk, this fund isn’t legally bound for SEBI registration. As compared to the other traditional financial instruments, these funds are riskier which makes them non-accessible to the masses. Nor the masses will be able to meet the eligibility criteria.
However, those who can invest in the list of hedge funds in India, view this fund as an important risk management tool by providing valuable portfolio diversification.
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 capitalize on this opportunity, XYZ Hedge Fund decided to take a long position in ABC Company’s stock and as a result, 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 realized gains on their investment.
It’s important to note that this hedge funds 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?
Since hedge funds in India are those mutual funds that are managed by the top fund managers in India, they tend to be quite expensive.
Hedge funds in India have a high entry barrier, with a minimum investment requirement of ₹1 crore, making them inaccessible to the general public. Additionally, these investment vehicles carry substantial risk, and the associated tax obligations can be significant.
So if you’re a beginner, consider investing in these funds once you have substantial experience in the field or when you have a hedge fund manager that you can completely rely on.
What are the Things to Remember Before Investing in Hedge Funds in India?
Here we have listed some of the factors to keep in mind while investing in hedge mutual funds in India.
- Read the Hedge Fund’s Documents and Agreements: Carefully read the documents as they contain the strategies of the fund, the location of the fund, and the risks anticipated by the investment.
- Understand the Risk: Since hedge funds in India are highly volatile, as a hedge fund investor you should consider all the risks involved.
- Expensive: Since the minimum ticket size is ₹1 crore which is slightly high for an average investor, therefore, be considerate before putting in this amount.
- High Fees: These fees can eat into your hedge fund returns, so it is important to understand the fees 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 funds 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, it is advisable to invest in these financial instruments only if your risk tolerance aligns with your goal.
FAQs
The hedge funds meaning is that it pools capital together. Similar to mutual funds but only from accredited high-net-worth individuals and institutional investors
A wealthy individual who can afford to invest in a hedge fund may be drawn to the fund’s manager’s reputation. The specific assets in which the fund has invested in, or the unique strategy that it employs.
Hedge fund vs mutual fund, pooled investment vehicles, 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.
The biggest hedge fund in the world is Bridgewater Associates, which was founded by Ray Dalio in 1975. As of March 2022, Bridgewater had $126.4 billion in assets under management.
Hedge fund examples are Motilal Oswal’s offshore hedge fund, Munoth Hedge Fund, Quant First Alternative Investment Trust, IIFL Opportunities Fund, India Zen Fund, etc.
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 degree 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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