What are hedge funds?

A hedge fund is an investment avenue 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, they are categorized as Alternative Investment Funds (AIF). It is because they invest in private equity, currency, venture capital, options, futures, and real estate, to name a few. To qualify as a hedge fund, the hedge fund 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 strategies, the fund manager attempts to maximize the return of the investors.

Characteristics of hedge funds

• Minimum investment: The minimum investment for a hedge fund 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 hedge fund investors.
• Fees: 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 is followed globally but not restricted to these numbers.
• Portfolio: Hedge funds have a diversified portfolio ranging from equities, bonds to derivatives, private equity, currencies, and venture capital. Hedge funds 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 are restricted monthly or quarterly. Hence they aren’t highly liquid when compared to other investment avenues.
• Risks: Hedge funds are prone to huge losses. Hedge funds, though manage risk, are considered high-risk investments due to their aggressive nature. They are also exposed to fund manager risks.
• Taxation: Hedge funds in India are heavily taxed. They come under the Category III of AIF, which are taxed at 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 of a hedge fund, 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 be suffered.

How do hedge 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. Hedge funds are an alternative to regular investments, and hence investors choose them for diversification.. A hedge fund can have 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. Here are some common strategies they use.

• Global Macro Strategy: Hedge 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 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: Hedge fund 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: Hedge fund managers invest in equity securities. They take long or short positions 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?

Hedge funds are privately pooled investment funds, and unlike mutual funds, not all investors can invest in hedge funds. High net worth individuals (HNIs), banks, insurance companies, and pension funds can invest in hedge funds. Hedge funds have a minimum investment of INR 1 crore. Investing in them isn’t cheap, either. They have a high expense ratio. Hedge funds are highly risky too. The tax on these funds is high as well.

Hedge funds are suitable for financially well-off investors, who have surplus funds to invest and can go the extra mile by taking high risks to earn an additional return. Investors also have to consider the costs involved in investing. Investing in hedge funds is a costly affair. The tax on hedge funds is pretty high too. The hedge fund is exposed 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 before investing in hedge funds.

Expenses and Taxation of Hedge Funds

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

Hedge funds fall under the Category III of AIF and are taxed at 42.74% on annual earnings over INR 5 crores. Category III AIF implies that returns are taxed at the investment fund level. Therefore, the unitholders are not obliged to pay tax. 

Advantages and Disadvantages of Hedge Fund

Advantages of investing in a Hedge Fund are:

• 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 associated with the fund being managed by a single fund manager is eliminated as multiple managers manage hedge funds. 
• 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. 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. 
• 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 of investing in a Hedge Fund are:

• 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: Hedge funds are long term investment instruments and have lock-in periods. Therefore, these are not highly liquid investments. 

Hedge funds in India

Hedge funds were introduced in 2012 by SEBI under the SEBI (Alternative Investments Funds) Regulations 2012. Hedge funds fall under Category III of AIF in India. These funds are at a nascent stage and aren’t regulated right now. There are no separate taxation laws for hedge funds. They come under the taxation of AIF. They are taxed heavily. This might be one reason why hedge funds haven’t picked up a pace yet when compared to western countries.

Hedge fund investments have picked up 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 as it’s biased towards offshore investors.