Hedge Funds: Meaning, Working, Taxation, How to Invest In It

What is Hedging?

Hedging is an investment strategy to protect profits or limit losses of one asset by buying or selling another asset. In other words, it is when investors protect their investments from future price movements. 

It is a popular risk management technique where a hedge position is taken in the opposite direction to protect investments. Ideally, it is investing in two different investments with a negative correlation. The most common example of hedging is car insurance. Everyone takes car insurance to protect their car against damages and accidents. 

Hedging is used by individual investors, traders, and asset management companies, etc. The idea behind adopting the strategy is to minimize the potential negative impacts. However, it is important to note that hedging doesn’t protect an investment from losses, rather, it just reduces the impact of the negative consequence.

What is a Hedge Fund?

A hedge fund typically is an investment product that is formed by pooling investments from multiple investors. They are privately pooled investment funds that earn high returns by investing in non-traditional assets. In India, the categorization is under as Alternative Investment Funds (AIF). 

There are the funds that invest in private equity fund, currency, venture capital, options, futures, and real estate, to name a few. To qualify as a hedge fund, it should have a minimum corpus of INR 20 crore and a minimum investment of INR 1 crore from each investor.

Hedge means to protect against risk. By investing in multiple assets by applying various investing strategies, the fund manager attempts to maximize the return of the investors. 

Hedge Fund in India

Hedge funds were introduced in 2012 by Securities and Exchange Board of India . It’s introduction was under the SEBI (Alternative Investments Funds) Regulations 2012. It falls under Category III of AIF in India. These funds are at a nascent stage and lack regulation right now. 

There are no separate taxation laws for it. They come under the taxation of AIF. This might be one reason why the hedge fund industry hasn’t picked up pace yet when compared to the industry in the western countries.

It is picked up as investment product in India (when compared to 2012 levels) due to a better tech ecosystem and investor confidence in the Indian economy. But the tax regulations made last year have been discouraging onshore investors.

Features of Hedge Funds

• Minimum investment: The minimum investment is INR 1 crore. Only high net worth individuals (HNIs), banks, insurance companies, and pension funds can invest in hedge funds. SEBI, like mutual fund investors, doesn’t protect fund investors.
• Fee Structures: The expense ratio for hedge funds can be around 2%. The managers also charge on the profits earned. The performance fee is approximately 20%. The two-twenty rule of fee structures is followed globally but not restricted to these numbers.
• Portfolio: Hedge funds have a diversified portfolio ranging from equities, bonds to derivatives, private equity fund, currencies, and venture capital. It can invest in non-traditional asset classes and hence have a diversified portfolio.
• Liquidity: Hedge funds have lock-in periods and are not highly liquid. The withdrawals can be monthly or quarterly. Hence they aren’t highly liquid in comparison to other investment avenues.
• Risks: They are prone to huge losses. Though manage risk, are considered high-risk investments due to their aggressive nature. There is also an exposure to fund manager risks.
• Taxation: The taxation on hedge funds are heavy in India. They come under the Category III of AIF, the tax rate is 42.74% on annual earnings over INR 5 crores.
• Absolute return products: There are no benchmarks for hedge funds to know their relative performance. Their performance is independent and measured in absolute terms.

Hedge Fund Manager:

There can be multiple managers, and sometimes the manager might invest their own money in the fund. It ensures safety for investors. The fund can be prone to the manager’s risk as well. Due to the inefficiency of the manager, the fund’s performance can suffer.

It was introduced in 2012 by Securities and Exchange Board of India

READ MORE: Hedge Fund Managers

How do Hedge Mutual Funds Work?

Hedge funds returns show the fund manager’s capability to extract high returns in the current market situation. A hedge fund manager plays a vital role in earning returns. These are an alternative to regular investments, and hence investors choose them for diversification. 

The fund strategy often involves more than one manager to manage the investments. Investors get personalized service from these managers as much research goes into this before they choose an asset for investment. Managers use multiple strategies from time to time to earn good returns.

Hedge Fund Strategies

Here are some common strategies they use. 

• Global Macro Strategy: The fund managers use economic variables, evaluate their impact on markets, and develop strategies to invest. This strategy is based on future movements rather than valuations. They apply various quantitative techniques to derive the holding period or long-short positions or short sell of the investment.
• Event-Driven: Hedge fund managers invest based on events like mergers and acquisitions, shareholder buybacks, financial distress, tenders, and debt exchanges. They use fundamental analysis to invest in equity or credit positions.
• Relative value: The portfolio managers invest based on arbitrage opportunities in equity, fixed income, or derivatives. They use fundamental and quantitative analysis to decide on what type of security to invest, when and for how long.
• Equity: The portfolio managers invest in equity securities. They take long or short positions or short sell in the underlying security, or derivatives of the security to capture a corporate event, or take advantage of low valuations.
• Multi-strategy fund: Hedge fund managers use multiple fundamental and quantitative techniques to arrive at an investment decision. They can concentrate on a specific sector for holding equity but might go long or short in various other sectors to take advantage of a bull or bear phase. By using multiple strategies in one fund, the hedge fund manager can maximize returns and minimize risks.

Who Can Invest in Hedge Funds?

These are privately pooled investment funds. Unlike mutual funds, not all investors can invest in it. High net worth individuals (HNIs), institutional investors, banks, insurance companies, and pension funds can invest in it. The investors such as banks, institutional investors, etc have an advantage of huge capital with research and capital management experts along with portfolio managers.

It has a minimum investment of INR 1 crore. Investing in them isn’t cheap, either. They have a high expense ratio. As an investment vehicle, it is highly risky too. The tax on these funds is high as well. It requires a risk tolerance along with complex strategy.

Hedge fund strategy is suitable for financially well-off investors, who have surplus funds to invest and can go the extra mile by with their risk tolerance. Investors also have to consider the costs involved in investing. Investing in it is a costly affair. The tax on it is pretty high too. There lies an exposure to fund manager risks. 

The investor has to have faith in the fund manager before he/she invests in it. Hence, investors have to consider all these along with risk and returns factors before investing in it.

Expenses and Taxation

The structural complexity of the hedge funds makes them costlier when compared to regular mutual funds in terms of management fee. Internationally, hedge funds follow the ‘Two-Twenty Rule’. As per the rule, expense fee is 2% of the total assets and 20% of the total returns as a performance fee. However, in India, there isn’t a specific management fee. The expense ratio is around 2% or less, and the performance fee varies between 10% to 15%.

It falls under the Category III of AIF. The applicable tax rate is 42.74% on annual earnings over INR 5 crores. Category III AIF implies that tax on returns are at the investment fund level. Therefore, the unitholders are not liable to pay tax. 

Recommended Read: Capital Protection Funds

Advantages and Disadvantages of Hedge Fund

Advantages

• Diversification: The complex and sophisticated strategies used by the fund managers to manage the fund makes them better than traditional investments in terms of risk assessment. The risk and returns associated with the fund being managed by a single fund manager. It is eliminated as multiple managers manage it.
• Managerial Expertise: A wrong investment decision can be a costly mistake. It requires a lot of experience and analytical capability to make an investment decision for such a complex investment vehicle. Therefore, decisions are made with extreme prejudice.
• Personalized Portfolio: As the minimum investment sum is high, investors get the best services. One such service is getting a customized portfolio and managed by a portfolio manager. 
• Low Correlation: Hedge fund investments are independent of the market index. Hence these are less sensitive to market fluctuations. As they rely less on fixed income markets, their portfolio returns are higher. This reduces overall portfolio volatility.

Disadvantages:

• High Minimum Investment: Hedge funds have a high minimum investment, which is not less than INR 1 Crore. This makes it impossible for an average investor to invest. 
• Liquidity Risk: These are long term investment instruments and have lock-in periods. Therefore, these are not highly liquid investments. 

Hedging in the Stock Market

• Securities Market: The equity market is highly volatile and is impacted by many internal and external factors. To protect equity investments against securities risk, traders and asset managers hedge their positions. 
• Commodities Market: The prices of commodities rise or fall depending on the demand, supply, weather conditions, etc. Agricultural commodities, metals, oil etc., are exposed to commodity risk. Thus, hedging against these assets helps in minimizing potential losses. 
• Interest Rate: The borrowing and lending rates are revised often. Thus, to minimise the impact of interest rate risk, investors and asset managers hedge their positions. 
• Weather: Weather derivates are instruments that help hedge against financial losses concerning adverse weather conditions like droughts, floods, hurricanes, etc. 
• Currency: Currency hedging minimizes the impact of currency changes on an investment. Often, a hedge position is taken to protect investments against fluctuations in the value of the country’s currency in which the investment are held.

Explore:

• Hedge Fund vs Private Equity: Which is Better Investment?
• Hedge Fund vs Mutual Fund: Which is Better Investment?
• Who are Hedge Fund Manager?

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