Hedge Fund: Meaning, Strategies, Investment Explained

Are you looking for investment options beyond traditional assets like stocks and bonds? Many Indian investors are now searching for smarter, more flexible ways to grow their wealth. For high-net-worth individuals (HNIs), hedge funds have emerged as an alternative offering potential returns higher than conventional assets.

Yet, for most people, hedge funds remain misunderstood, exclusive, and complex.

So, what is a hedge fund, and how does it work? Let us explore the hedge fund meaning, strategies and regulations in India.

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 in which a hedge position is taken in the opposite direction to protect investments. Ideally, it involves investing in two different investments with a negative correlation. The most common hedge fund example is car insurance. Everyone takes car insurance to protect their car against damages and accidents.

Hedging is used by traders, institutional investors, and asset managers to reduce the impact of volatility. Although it doesn’t eliminate risk entirely, it just aims to reduce the impact of the negative consequence.

What is a Hedge Fund?

A hedge fund is an investment product formed by pooling investments from multiple investors. These privately pooled funds earn high returns by investing in non-traditional assets. They can invest in commodities, derivatives, currencies, real estate, bonds, equities, to name a few.

Hedge funds in India are classified under Category III of the SEBI (Alternative Investment Funds) Regulations 2012. They became legal and regulated only in 2012. Hedge funds in India are still in the early stages and face heavy taxation and lower regulatory clarity, which has slowed their growth compared to their global counterparts.

Many people wonder how to start a hedge fund in India? The corpus must be at least ₹20 crore and a minimum investment of ₹1 crore from each investor.

Features of Hedge Funds

Here are some important features that distinguish hedge funds from traditional investment vehicles:

• Minimum Investment: In India, the minimum investment in a hedge fund is ₹1 crore per investor. This high threshold makes hedge funds accessible only to HNIs and institutional investors.
• Fee Structures: The expense ratio for hedge funds can be around 2%. The managers also charge on the profits earned. The performance fee can be around 20%. The two-twenty rule of fee structures is followed globally but not restricted to these numbers.
• Portfolio: Hedge funds have a diversified portfolio that includes equities, bonds, derivatives, commodities, and currencies.  
• Liquidity: Hedge funds are not as liquid as mutual funds. Withdrawals may only be allowed monthly or quarterly, and there are usually lock-in periods.
• Risks: Despite their name, hedge funds are not risk-free. They are high-risk investments due to leveraged strategies and exposure to market volatility.
• Taxation: Hedge funds are heavily taxed in India. They fall under Category III of AIF, and the tax rate is 42.74% on annual earnings over ₹5 crores.

Category III AIFs are taxed at the fund level, meaning investors (unitholders) are not directly liable to pay tax on returns. Instead, taxes are deducted before profits are distributed, lowering the net returns investors receive.

• Absolute Return Products: Hedge funds do not have benchmarks for determining their relative performance. Their performance is independent and measured in absolute terms.

How do Hedge Mutual Funds Work?

Hedge fund investment returns show the fund manager’s ability to offer high potential returns in any market situation. A hedge fund manager plays a vital role in earning returns. 

The fund strategy often involves more than one manager managing the investments. Investors get personalised 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: This involves investing based on economic trends and macroeconomic events like interest rate changes, political instability, or commodity price shifts. Managers apply various quantitative techniques to derive the holding period, and long-short positions.
• Event-driven: These strategies revolve around corporate events such as mergers, acquisitions, bankruptcies, or buybacks. The fund capitalises on temporary mispricing during such events.
• Relative Value: This strategy exploits pricing inefficiencies between related securities, such as convertible bond arbitrage or fixed-income arbitrage. They use fundamental and quantitative analysis to decide on what type of security to invest in, when and for how long.
• Equity: In equity hedge strategies, managers take long and short positions in equities and equity derivatives. They aim to capitalise on stock price movements while hedging against market risks.
• Multi-Strategy Fund: Some hedge funds combine several strategies within one portfolio. Depending on market conditions, a hedge fund manager may invest long in one sector while shorting another.

Who Can Invest in Hedge Funds?

Not everyone can invest in hedge funds. These are meant for sophisticated investors, such as:

• High-net-worth individuals (HNIs)
• Institutional investors
• Banks and insurance companies
• Pension and endowment funds

Since it has a minimum investment of ₹1 crore, these funds are not accessible to retail investors. Investors should also be prepared for high risk, low liquidity, high tax and complex fee structures.

Advantages and Disadvantages of Investing in a Hedge Fund

Advantages

• Diversification: The complex and sophisticated strategies used by fund managers to manage funds make them better than traditional investments in terms of risk assessment. 
• Managerial Expertise: Investments are handled by highly experienced hedge fund managers who use advanced analysis and strategies.
• Personalised Portfolio: As the minimum investment sum is high, investors receive tailored services and dedicated fund management.
• Low Correlation: Hedge fund investments are typically independent of the market index but not always. Hence, these are less sensitive to market fluctuations. 

Disadvantages:

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

Final Thoughts

Hedge funds are powerful investment vehicles for those who understand the risks and can afford the high entry barriers. With complex strategies and the potential for high returns, they can offer diversification and exposure beyond traditional markets. 

However, before investing, due diligence, understanding the hedge fund manager’s approach, and considering tax implications are important. If you’re exploring hedge fund investment in India, make sure you are financially equipped and are comfortable with high-risk.

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