What are Hedge Funds?

Hedge funds are sometimes referred to as “rich man’s mutual funds” because they cater to and manage the investments of large institutional investors and high-net-worth individuals (HNIs). These funds use advanced trading strategies to hedge price risk and generate high returns for their investors.

Let’s understand in detail what hedge funds are, how they work, their types, and strategies.

What Are Hedge Funds?

Hedge funds are investment vehicle that pools money from institutional investors and HNIs and uses aggressive trading strategies to generate high returns for their investors. These funds are privately managed and are classified as Category-III Alternative Investment Funds (AIFs) by SEBI.

Unlike general stocks and ETFs, they are not listed on the stock exchanges and are governed under the SEBI (Alternative Investment Funds) Regulations, 2012.

How Do Hedge Funds Work?

To generate high returns for their investors, hedge funds use various trading techniques and strategies. These funds actively trade equities, debt, and derivatives contracts such as Futures and Options (F&O) to deliver returns in rising and falling markets. They also invest in real estate and currencies to diversify their portfolio and manage risks.

To invest in hedge funds, investors must invest a minimum of ₹1crore with the entire fund minimum corpus set at ₹20 crores. Investors are also required to pay hefty management fees, a percentage of total assets under management, and performance fees, which are a percentage of the fund’s profit.

Most hedge funds follow the ‘2 and 20’ model, under which they charge 2% of the total assets managed every year as a management fee and keep 20% of the total profits they earn.

Types of Hedge Funds in India

The following are the different types of Hedge Funds in India.

Equity Hedge Funds

Equity hedge funds predominantly invest in shares and use derivatives to hedge against price risks. These funds aim to generate significant returns, regardless of the prevailing market conditions. For example, they take long (buy) positions when markets are expected to rise and short (sell) positions when a downturn is expected to book profits and prevent losses.

Global Macro Hedge Funds

Global Macro funds create investment strategies based on the broader macroeconomic and political conditions. These funds aim to generate profits from significant market movements, changes in interest rates, inflation, and currency fluctuations globally.

Event Driven Hedge Funds

These hedge funds generate returns by capitalising on market mispricings due to certain corporate-specific events such as mergers, restructurings, or bankruptcies. The funds analyse the potential short to long-term impact of these corporate events on the company’s stock.

Quantitative Hedge Funds

These hedge funds use advanced mathematical algorithms, artificial intelligence, and statistics to identify potential trading opportunities by focusing on recurring market patterns.

Arbitrage / Relative Value Funds

As the name suggests, the Arbitrage hedge funds aim to capitalise on the temporary price discrepancies between securities to generate profits. They do so by buying the undervalued and selling the overvalued securities simultaneously to book risk-free profits.

How Are Hedge Funds Taxed in India?

Since hedge funds operate as Category III AIFs, any income earned, whether through capital gains, dividends, or interest, is taxed directly at the fund level. The fund pays the applicable taxes before distributing profits, which reduces the net returns earned by investors.

Risks & Returns of Investing in Hedge Funds

Hedge funds are considered high-risk investments due to complex trading strategies. They are also relatively illiquid since they are not publicly traded investments. However, hedge funds often have the potential to outperform traditional investments such as mutual funds and fixed deposits.

Who Should Invest in Hedge Funds?

Only institutional investors and HNIs with massive investment capital are allowed to invest in Hedge funds since they charge hefty management fees due to a high expense ratio and require a minimum investment of ₹1 crore per investor.

Hedge funds are suitable for financially strong investors with a high risk appetite and surplus funds seeking passive investment opportunities.

FAQs

What is a hedge fund, and how does it work?

Hedge funds are investment vehicle that pools money from institutional investors and HNIs and uses various trading strategies to generate high returns for their investors.

What is the difference between hedge funds and mutual funds?

Only institutional investors and HNIs are eligible to invest in hedge funds as it requires a minimum investment of ₹1crore per investor. Anyone can invest in mutual funds, and the minimum investment requirement is ₹100.

Who can invest in hedge funds in India?

Institutional investors and High Networth Individuals (HNIs) can invest in hedge funds in India.

Are hedge funds risky investments?

Yes, hedge funds are considered high-risk, high-reward investments and are suitable for investors with a high risk tolerance.

How are hedge funds taxed in India?

In India, hedge funds come under Category III Alternative Investment Funds (AIFs) as per SEBI and are taxed at the fund level. The fund pays the applicable tax liability and then distributes the remaining profit to investors.