What are Hedge Funds?

As the term “Hedge” suggests, the hedge funds are focused on keeping the investor’s money safe and free from any risk. It pools money from various accredited investors such as insurance companies, banks, endowment funds, and high net-worth individuals, for investment with different assets to generate returns.The assets can be derivatives, currencies, bonds, equities, or convertible securities. These funds are not registered at SEBI and generally operate as foreign investment corporations or privately-owned investment partnerships. Also, they are not required to share their NAV on a regular basis, like other funds.Hedge funds aggressively manage their investor’s money to safeguard it from risks. They extensively use complex trading techniques to construct portfolios and minimising risks. Also, they deploy risk management techniques such as derivatives, short-selling, leverage, etc. to enhance performance.

● Available Only to Accredited Investors

Only those individuals or firms with a higher annual income and net worth qualify to invest with hedge funds. The annual income must exceed $200000 in the past 2 years or a net worth that exceeds $ 1million, which is acceptable. The net worth must be stated after excluding the investor’s primary residence. These high-worth investors are deemed to be suitable for handling potential risks associated with a wide investment horizon.

● Investment in Diversified Portfolio

Hedge fund holds a comprehensive portfolio that includes equities, bonds, stocks as well as real estate or currencies, etc. It can practically invest in anything, and the investment scope is limited only by its mandate.

● Higher Fees

Hedge funds fee structure includes both the expense ratio and performance fee. This implies that there is a fixed fee of 2% and 20% is charged from the profits generated. Hence the total fee becomes relatively higher.

● Aggressive Investment Strategies

For deriving higher returns with a limited risk, the hedge fund manager adopts different and aggressive management strategies in comparison to traditional fund managers. Since there is a lack of regulations, there is a wide choice of investment techniques before the hedge fund manager. Such aggressive techniques are not feasible with highly regulated investment.

● Lock-in Period

These funds are illiquid in nature since the fund managers can impose withdrawal limits and lock-in the amounts for 2 or more years. Hence, the investment may be long-term before you obtain profits out of it.

● The success of hedge funds depends largely on the fund manager's skills and farsightedness than the market scenario. They diversify the investments across different assets to reduce the risk and generate profits even in the volatile markets.● The fund manager can use a sell-short strategy if there are chances of prices to drop in the future. He can sell the shares and buy them back later for a lower price, as per this strategy.● Arbitrage strategy can also be used by the managers to take advantage of inefficient or different pricing across the markets. Here, the same asset can be purchased and sold at different prices in different markets to generate profits out of the price difference.● The investment can also be made with major events in the market such as spin-offs, acquisition, or merger of companies, etc.● The fund manager must be an expert in exploiting opportunities where assets are available at lower prices. For example, if there is a company facing financial losses and expected to go insolvent, their stocks may be available at much lower prices. The manager may judge the situation and future prospects to decide if buying the shares can prove profitable later on.

There are broadly three types of hedge funds available in the market:

1. Domestic or Onshore Funds

It serves the residents of the country where the fund belongs to. Hence it is open to only those investors who are subjected to the taxation system of the country of the fund.

2. Offshore Funds

An offshore hedge fund is one that is originated outside your country and is not restricted to serve only its own country’s residents.

3. Funds of Funds

Funds of funds refer to those mutual funds that invest in different hedge mutual funds than investing in individual securities.

● Hedge funds are complicated funds that use complex trading techniques such as short-selling and derivatives techniques that are suitable for large investors. You must do detailed research and tracking of different investments before you choose to invest with hedge funds.● Since hedge funds are not registered with SEBI, they lack proper regulations and operate on their own. This can make hedge funds risky. You need to understand this aspect before investment and look for reliable hedge funds.● A minimum investment of Rs. 1 crore is needed for any individual to invest in hedge funds. Such a huge investment may not be feasible for everyone considering the fact that it may be a long-term investment with associated risks.● Before investing, take your time to understand the hedge industry in India, its age, the key players of hedge funds, their strategies, worth, risks involved and advantages and disadvantages of investing.● Go through the finance magazines, blogs and different websites to gain a better understanding. Also, you can talk to the hedge fund managers or investors about their experience with investment in hedge funds. It is a great idea to involve a financial advisor before you choose to invest.● Since hedge funds are costlier, you need to be financially well off to invest with it. Also, you must be ready for the risk involved with these funds since the managers trade aggressively to keep up with the changes in the market.● You must retrain yourself from investing in hedge funds if you do not have sufficient experience or knowledge about it.

You must have a strong financial worth and feasibility to take an aggressive risk before opting for hedge funds. Also, good knowledge about the hedge funds, including ground realities, strategies and regulations is a must. Take your time to understand different aspects, especially if you are a first-time investor before arriving on any decision.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.