What are hedge funds?

Find out everything you need to know about hedge funds

What are hedge funds?

If you are reading this, you are probably interested in learning more about investment terms. And if so, you must have already read or heard of the various types of funds, such as mutual funds, exchange-traded funds, money market funds, pension funds – and hedge funds. 

Hedge funds are so named because they aim to ‘hedge’ risks to investors’ money through a diverse portfolio boasting of asset classes such as derivatives, equities, bonds, currencies, and convertible securities. In fact, because of this, they are also dubbed ‘alternative investments’.

Related: Simple ways in which you can diversify your financial portfolio 

Differences with mutual funds

Hedge funds are similar to mutual funds in the sense that both are pooled money, with fund managers typically creating a common fund for trading and investing on their clients’ behalf. However, unlike mutual funds, hedge funds are not open to every individual investor; they are made accessible selectively to those with considerable assets, as well as to institutions.

This is primarily because hedge funds, unlike most mutual funds, usually resort to substantial leverage – i.e. take risks – holding both long and short positions (including positions in listed and unlisted derivatives).

Hedge fund managers are highly qualified experts who are also expensive: their fees can be as high as 15-20%, much higher than the normal expense ratios for mutual funds.

Also, given the risks, it is recommended not only for investors with an appetite for risks, but also who are well off. SEBI recognises this, and as per its regulations on alternative investment funds (AIF) such as hedge funds, the minimum investment ticket size is Rs 1 crore for an AIF.

What this means is that under SEBI guidelines, only HNIs and institutional investors are permitted to invest in AIFs; so much so, the minimum corpus for each scheme of AIF is set at Rs 20 crore. Compare this with mutual funds, which are accessible to anyone who can start a SIP with an amount as little as Rs 500.

Related: Direct Mutual Funds- should you add them to your investment portfolio? 

Differences with PE Funds

As stated earlier, a hedge fund is one type of AIF, which have been classified into three broad tiers as per SEBI regulations – I, II, and III. The first group comprises angel, venture capital, social and infrastructure funds, the second has PE real estate and distressed funds, while hedge funds fall in the third category.

Hedge funds also differ from PE (and VC) funds on several important counts; let’s see how:

  • Managers of hedge funds have no restrictions on buying or selling a wide range of assets, while those of PEs can hold only long portfolios;
  • Hedge funds can take leverage positions, which PE cannot;
  • Hedge funds look to reap profits from market mispricing, while PE funds rely more on economic growth to drive returns;
  • Hedge funds have low holding period, sometimes as low as intraday, while PEs have a much longer holding period of 5-7 years;
  • Managers of hedge funds are basically financial investors, whereas PE investment involves a certain degree of operational control on the investee company;
  • Hedge fund performance is calculated on a monthly/quarterly basis (given the short investment horizon), while PE funds see returns only after 5-7 years;
  • PE investors simply cannot withdraw capital until the end of a fund’s tenure, while the majority of hedge funds invest in relatively liquid assets.

Related: Equity Mutual Funds vs Stocks: Where to invest?

Hedge fund regulations

Hedge fund managers take greater risks than that usual for mutual funds, though this does not mean they are not bound by laws; in India, a regulatory framework for the protection of their clients’ investments is ensured by three key regulations:

  • The Securities and Exchange Board of India (SEBI) (Alternative Investment Funds) Regulations 2012;
  • The SEBI (Foreign Portfolio Investor) Regulations 2014;
  • Foreign Exchange Management Act 1999 (relating to investments by offshore investors/hedge funds into onshore hedge funds).

Apart from the two SEBI regulations, the securities regulator also issues circulars at regular intervals announcing new compliance rules, if any, while RBI does the same for new regulations relating to onshore hedge funds.

Related: Clueless about investing in stock markets? Here are some options 

It should be noted that prior to the AIF Regulations of 2012, which categorised hedge funds as Category III AIFs with complex or diverse trading strategies, India had no specific regulations governing onshore hedge funds.

However, though SEBI had introduced regulations in May 2012, it also sought over the next few years to relax regulatory mechanisms so as to boost investments, leading to a spurt in inflows into the hedge funds market in 2017.

SEBI also took several steps to enhance institutional participation in the commodity derivatives markets, with an aim to boost liquidity, right asset pricing, and price risk management.

  • In June 2017, it permitted Category III AIFs to participate in the commodity derivatives market provided they followed reporting norms and certain conditions such as portfolio broad-basing;
  • It introduced an online system for registration, complying with reporting requirements, and meeting filing requirements;
  • SEBI also made it mandatory for existing AIFs to activate their accounts on the SEBI portal for filing compliance reports online.

Related: Short term investment options for high returns

Marketing regulations

There are SEBI specifications in place specifying who can market hedge funds. For onshore hedge funds, SEBI guidelines allow AIFs to be marketed only through private placement or by issuing an information memorandum for private placement memorandum (PPM).

What are hedge funds?

On the other hand, India has no specific regulations relating to the marketing of offshore hedge funds. Such activities come under the purview of its foreign exchange regulations such as the Foreign Exchange Management Act 1999 (FEMA) and the Liberalised Remittance Scheme of the central bank.

For instance, under India’s forex regulations, Indian residents can invest in foreign securities only as per FEMA provisions, and regulations and circulars issued by the RBI under FEMA. This means Indians can send up to $250,000 abroad for investing in foreign securities, but only under the banking regulator’s Liberalised Remittance Scheme.

Related: 7 Government schemes to aid economic development and financial stability that you can benefit from 

Moreover, banks – both foreign and Indian – need RBI approval for marketing funds in India and for acting as agents for overseas funds and other foreign financial services company. In a similar fashion, offshore hedge funds come under domestic regulations on foreign exchange remittance limits and process, as well as the Companies Act 2013. 

Hedge fund performance

A Bloomberg report in May 2018 identified heavy taxation as a key factor stalling the growth of the hedge fund segment in India, and quoted stakeholders as saying that Indian hedge funds could end up managing as much as $12 billion within five years if the authorities implemented some tax reforms.

Bloomberg quoted data from Eurekahedge, an alternative investment research firm specialising in hedge fund databases, to put the total investments managed by domestic hedge funds as of May 2018 at just $603 million. As against this, its own data showed mutual funds as managing the equivalent of $284 billion. 

In a separate report released in April 2018, Eurekahedge said while Indian hedge funds “outperformed their global peers by a large margin in 2017, riding on the back of the Indian equity market’s exceptional performance over the year”, various concerns clouded their chances in 2018, these being:

  • Slowing economic growth;
  • Slow financial reforms;
  • Capital outflow risks; and 
  • The twin headaches of fiscal deficit and a current account deficit that the government was grappling with.

Related: How debt and equity based mutual funds differ in risk

“Despite the numbers indicating that average Indian hedge funds may not be able to generate enough alpha to justify their fees, we must remember that the Indian hedge fund industry is still relatively young compared to those of North America and Europe,” the Eurekahedge report said. 

“As of now, this inability to generate excess returns, combined with the various challenges the Indian economy is likely to face in the near future, may pose headwinds for the country’s young and growing hedge fund industry,” it added.

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