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Hedge Funds

Hedge mutual funds are a type of mutual fund that are set up as private investment limited partnerships. Confused? Well this product is a bit complex.

In Securities and Exchange Board of India (Sebi’s) words, “Hedge funds, including fund of funds, are unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are not subject to the same regulatory requirements as mutual funds.”

There are different types of hedge funds depending on the securities they invest in and the kind of strategies used to manage them.

Regulatory requirements:

Hedge funds in India do not need to be necessarily registered with Securities and Exchange Board of India (Sebi), our markets regulator or disclose their NAVs at the end of the day. All other mutual funds are required to follow these regulatory requirements.

How do Hedge funds work?

These funds use different types of trading techniques because of the securities and assets they invest in. They invest in equities, debt and also derivatives.

Examples of derivatives include futures and options. Like with equities and debt securities, the trading technique could be trading in a stock market or buying it directly from the company in a private placement.

For example, with futures, there is a right or an obligation to buy or sell an underlying stock at a pre-determined price, date and time. Options trading are the same but without an obligation. Investing in such securities automatically diversifies trading techniques.

Hedge mutual funds pool money from larger investors like high networth individuals (HNI), endowments, banks, pension funds and commercial firms. They fall under the AIF (alternative investment funds)-category III. This pooled money is used to invest in such securities in national and international markets.

There is a long list of securities where hedge mutual funds can invest: Equities, bonds, real estate, currencies, convertible securities, derivatives among others.

What are the different types of hedge funds in the market?

There are mainly three types:

  • Domestic hedge funds: Domestic hedge funds are open to only those investors that are subject to the origin country’s taxation.
  • Offshore hedge funds: An offshore hedge fund is established outside of your own country, preferably in a low taxation country.
  • Fund of funds: Fund of funds are basically mutual funds that invest in other hedge mutual funds rather than the individual underlying securities.

What are the different strategies of hedge fund investing?

These funds can also be categorised by the complex strategies their fund managers adopt to maintain their funds.

  • Event driven: There are few event driven hedge mutual funds that invest to take advantage of price movements generated by corporate events. For example: merger arbitrage funds and distressed asset funds.
  • Market neutral: There are also some market neutral funds that seek to minimise market risks. This category included convertible bonds, short and long equity funds and fixed income arbitrage.
  • Long/Short selling: By definition, short-selling means that you sell a security without actually buying it but with the notion of buying it at a predetermined future date and price. You hope for the share price to drop on this predetermined future date and book profits.
  • Arbitrage: An arbitrage-oriented strategy means buying a security in one market where the security is trading at a lower price and then selling the same security at a higher price in another market to book some profit. This can also be used for buying and selling two very highly correlated securities simultaneously to book profit when markets are moving sideways. This is called relative value arbitrage. Both the securities could be from one asset class or multiple ones.
  • Market-driven: Hedge mutual funds also take advantage of global market trends before they make the decision to invest in securities. They look at global macros and how they will impact interest rates, equities, commodities and currencies.

These categories comprise the top hedge funds that are available in the market. However, there are also some other pooled investment vehicles which have some similarities with the varying types of hedge funds.

Fees and minimum investment:

The fee structure consists of both: a management fee which is generally less than 2% and a profit sharing technique which varies between 10 to 15%. The minimum ticket size to invest in hedge mutual funds is Rs 1 crore per investor and an entire fund needs to have a minimum corpus of Rs 20 crore.

How are hedge mutual funds taxed?

These funds fall under category III AIF and are taxed according to taxation rules applicable to AIF category III. Category III AIF, as of now, are not considered as pass through vehicles.

This means that the fund on the whole has to pay a tax when it realises gains or gets income in any form. In other words, hedge mutual funds are taxed at the fund level.

The tax obligation will not be passed through to the unit holders or its investors. This may be one of the reasons why they have not been able to take off in India. The high tax burden acts as a deterrent.

The taxes are withheld before the profits are distributed to you. This automatically curbs the returns that finally end up with the domestic investors.

What are Risk and Return Profile of Hedge Funds? 

The aforementioned points on relaxation of regulatory requirements speaks volumes on the high risk level that this product carries.

Apart from the fact that the underlying securities that top hedge funds invest in also carry high risk, the product is not legally bound for a Sebi registration or disclosure of NAV. These two points keep the rest of the funds under a close watch and closely regulated. This does not mean that Sebi leaves these funds unattended but no legal binding does work the risk level upwards.

We all know that risk and returns are directly proportional. Hedge fund returns, just like its risks, are on the higher side. Average annual returns can go as high as 15% as well and the credit for this is attributed to the hedge mutual fund managers.

Who should invest in Hedge Funds?

Since hedge funds are those mutual funds that are managed by experts, they tend to be quite costly. They can be easily afforded by those who are financially sound, have surplus funds, and have a good risk appetite.

Also, if you are a beginner, you might need the assistance of a fund manager to take care of your hedge funds. Such managers have a high expense ratio i.e the fee charged by them is quite heavy. Thus, consider investing in hedge funds once you have substantial experience in the field or you find a fund manager whom you can trust confidently.

How are hedge mutual funds different from mutual funds?

The basic structure of these funds is just like other mutual funds. They are a pooled investment vehicle. They collect money from a pool of investors and use that money to invest in other assets and there is a fund manager who manages the fund as well.

Here’s a table that explains the difference between mutual funds and hedge funds:

Sr No. Category Hedge Mutual Funds Mutual funds
1. Regulatory requirements No sebi registration required or disclosure of NAVs Disclosure of NAVs at the end of the day is necessary

Sebi registration is mandatory

2. Investor category HNIs, banks, commercial firms, Any domestic investor
3. Underlying securities Equities, money market instruments, currencies, real estate, derivatives, convertible securities Equities, money market instruments, cash
4. Risk Very high Comparatively lower
5. Minimum ticket size Rs 1 crore Not uniform but as low as Rs 500 in some funds
6. Minimum corpus Rs 20 crore for a hedge fund Not defined
7. Investment strategy Short selling permitted Mutual funds cannot do short selling

Things to keep in mind before investing in hedge mutual funds

  • Complicated products: These funds in short-selling and derivatives trading. Such trading techniques are adopted only by larger investors. If you are looking to invest, you need to be prepared for a whole lot of research and investment tracking from your end.
  • Risky: Dealing in derivatives does make the product risky but what adds to the risk element is the low level of regulation. Sebi does not require hedge mutual funds to be registered with them so the fund and their investors are kind of on their own.
  • Expensive: The minimum investment ticket size is Rs 1 crore so for a regular investor, putting in such a huge amount in one investment may not be feasible.
  • Returns: Hedge fund returns are volatile so you need to be prepared for dips and upsides both.

Hedge mutual funds are complex in their structure and strategy. They invest in almost every asset so they are heavily diversified however strategies like arbitrage and long/short selling keeps it higher on the risk rack. As an investment product, explore these only if they align with your goals and do your due diligence in research before proceeding.

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