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What is a hedge fund?

A hedge fund is an investment vehicle that pools capital from high-net-worth investors and invests in a wide variety of assets. Hedge funds have complex portfolio-construction and risk-management techniques.

While reading about mutual funds, you might have come across the term ‘hedge fund’. At times people think that hedge funds are a type of mutual fund. But that is a mistake. Mutual funds and hedge funds both pool money from investors, which they invest on their behalf in different securities. However, the similarities end there. So what are hedge funds? Read on to find out.

(Read more: What are mutual funds?)

A hedge fund is an alternative form of investment open to high-net-worth individuals and families or institutions. It may be in the form of an offshore investment corporation or a private investment partnership. It collects money from investors and invests it in different types of securities. Hedge funds are managed more aggressively and use sophisticated and risky investment strategies.

What are the key characteristics of hedge funds?

Limited investor type:

In this case, ‘limited’ means that it is limited to investors who are high-net-worth families and individuals, pension funds, endowment funds, banks, and insurance companies. Hedge fund investors are ‘accredited investors’. They meet certain stipulations for investing in securities that are not open to the general public. In India, you require a minimum investment amount of Rs 1 crore to invest in a hedge fund.

Not regulated:

Securities market regulators such as the Securities Exchange Board of India (SEBI) do not regulate hedge funds. Hedge funds do not have to give reports, such as a periodic disclosure of net asset values (NAVs).

(Read more: What is NAV?)

Wide investment type:

Hedge funds invest in traditional stocks and bonds. They also invest in derivatives, real estate, currencies, mortgage products, and more. Hedge funds use both long-term and short-term investment strategies.

Use of leverage:

Leverage is an investment technique whereby hedge funds use borrowed capital to amplify returns. But leverage is a risky practice. It could significantly increase the returns or even wipe out a hedge fund.

Less liquidity:

It is more difficult to sell hedge fund shares. Mutual funds have a per-share price that is calculated every day. This price is the net asset value (NAV). You can use the NAV as a guide to sell your shares at any time. Hedge funds, in contrast, attempt to generate returns over a certain timeframe called the lock-in period, which is at least a year. During this time, investors cannot sell their shares. Moreover, investors can make withdrawals only at certain intervals. These intervals may be quarterly or bi-annual. (Read more: How to calculate NAV)

Fee structure:

Hedge funds have a fee structure known as ‘two and twenty’. This is because they charge a 2% asset management fee and a 20% cut of any profits. The asset management fee may range from 1% to 4% of the funds’ NAV. At times, hedge fund managers invest aggressively to achieve higher returns. This leads to increased risk for the investors.

Global macros strategy:

Hedge funds use long-short positions in large financial markets. This is also known as the global macros strategy. The fund manager aims to reduce market risks by investing in convertible bonds, arbitrage funds, long/short funds, and fixed-income products.

Some strategies employed by hedge funds

The returns from hedge funds often depend more on the skills of the hedge fund manager than on prevailing market conditions. Hedge fund managers attempt to generate good returns and reduce market exposure in spite of market movements. Here are some strategies they employ to achieve their fund objectives:

Selling short:

Hedge fund managers often sell stocks using borrowed money. Later, they buy back these stocks after their price falls.

Using arbitrage:

There are times when securities show inefficient or contradictory pricing. Hedge fund managers use this pricing discrepancy to their advantage.

Investing towards a future event:

Fund managers make use of major market events such as company mergers, acquisitions, and spin-offs. These events can influence the fund managers’ investment decisions.

Investing in securities that have high discounts:

When companies face insolvency or great financial stress, they may sell their securities at extremely low prices. Fund managers may buy these discounted securities after weighing the pros and cons of the investment.

What are the differences between mutual funds and hedge funds?

Here is a breakdown of the differences between mutual funds and hedge funds:

Category Mutual Funds Hedge Funds
Investor type and amount Open to all investors. Allow small investments as low as Rs 500 or Rs 1,000 Only open to high-net-worth investors. The minimum amount of investment in India is Rs 1 crore
Investment type Invest in regular financial instruments such as stocks and bonds
(Read more: How mutual funds work)
Other than regular financial instruments, they invest in risky and sophisticated instruments
Borrowing capabilities Limited borrowing capabilities Can borrow additional amounts. Can also bet on twice the total worth of their assets
Payment to managers Fund managers are paid irrespective of the fund’s performance Fund managers get a percentage of the returns that they earn for their investors. They also get an asset management fee between 1% to 4% of the fund’s NAV
Risk factor Less risky as they do not use complex investment strategies. They also stick to traditional and safer financial instruments Invest in riskier and more sophisticated financial investment instruments. Also use more complex investment strategies
Diversification The objective is to protect investors’ money. They do so by diversifying their investments Diversification is not necessary. They may take extremely concentrated investment decisions
Regulation SEBI regulates mutual funds in India. The Reserve Bank of India (RBI) regulates mutual funds if the AMC is promoted by a bank Not regulated by SEBI or RBI

WHAT NEXT?

We are almost at the end. Before you start investing in mutual funds, there are a few more important points to keep in mind like taxation. This can affect your total financial returns. To know about these factors, Click here

Why Capital gains report?
  • Snapshot of profit/loss
  • Reflects performance of your portfolio
  • Helps compute taxes
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