What is a Hedge Fund?

What is Hedge Fund?

According to the Securities and Exchange Board of India (SEBI), hedge funds, including fund of funds, are unregistered private investment partnerships, funds, or pools that are exempt from the same regulatory requirements as mutual funds and have the ability to invest and trade in a wide range of markets, strategies, and instruments, including securities, non-securities, and derivatives.

Hedge funds come in a variety of forms based on the securities they invest in and the management techniques they employ.

In India, hedge funds are not required to reveal their net asset values (NAVs) at the end of the day or to register with the Securities and Exchange Board of India (SEBI), our market regulator.  These regulations must be adhered to by all other mutual funds.
 

How Do Hedge Funds Work?

Because of the securities and assets they invest in, these funds employ a variety of trading strategies.  They make investments in derivatives, debt, and stocks.

 Derivatives include things like options and futures.  Trading in the stock market or purchasing it straight from the business through a private placement are two possible trading strategies, similar to those used for stocks and debt securities.

With futures, for instance, there is a right or a duty to purchase or sell an underlying stock at a specific price, date, and time.  Trading options is similar, except there are no commitments.  Purchasing such securities inevitably broadens one's trading strategy.

Larger investors such as banks, endowments, pension funds, high net worth individuals (HNI), and commercial enterprises contribute money to hedge funds.  They belong to category III of alternative investment funds, or AIFs.  These securities are purchased on both domestic and foreign markets using the pooled funds.

Equity, bonds, real estate, currencies, convertible securities, and derivatives are just a few of the many securities in which hedge funds can invest.

Hedge funds, like mutual funds, also manage pooled money. However, there are some important differences. Mutual funds largely cater to retail savers while hedge funds cater to high risk HNIs and institutions. Hedge funds have more flexibility in taking risk and creating structures. Hedge funds are also less regulated compared to mutual funds. Post the financial crisis of 2008, hedge funds have lost a lot of incremental money to passive strategies and ETFs. Here is a look at 10 interesting hedge fund strategies.

1. Hybrids or long/short equity

Long/short equity strategy entails simultaneously taking long and short positions in equity or equity derivatives. Such long short strategies can be fundamental, technical or quantitative. For example, hedge funds can do long short when they expect a stock or sector to outperform another stock or sector. Long short strategies are also employed when hedge fund expect mean reversion of ratios e.g. gold/silver ratio. Unlike mutual funds, hedge funds do not allow seamless entry and exit and the minimum barrier is also quite high. That is what enables such complex strategies.

2. Credit risk strategies

As the name suggests, such strategies normally entail going down the rating curve. For example, if an AA rated bond is as safe as an AAA rated bond but if yields are nearly 100 basis points higher, then it gives scope for credit risk strategies. Hedge funds make the best of such pricing inefficiencies. Credit risk hedge funds are normally active in downturns.

3. Vulture funds and distressed debt

This is a subset of credit risk strategies but is a lot more specialised and has a lot of legal nuances to it. When a company is unable to meet its financial obligations or is in a liquidity crisis (some PSU banks in India and NBFCs), its debt devalues. Vulture funds use fundamental analysis to identify undervalued investments. Such funds normally entail a long lock-in period considering their unique nature.

4. Fixed Income Arbitrage

An arbitrage is all about exploiting price differentials due to market related pricing inefficiencies. A simple example is if yields on the short end of the yield curve are higher than yields at the long end. It should actually be the other way round as longer tenure means higher risk. Such situations give rise to fixed income arbitrage. Fixed income arbitrage strategies include yield curve arbitrage and capital structure arbitrage.

5. Arbitrage on convertibles

Let take the example of a fully convertible debenture (FCD) or a partially convertible debenture (PCD). Such convertibles come with an embedded option to convert the FCD/PCD into a certain number of shares at a pre-determined price. If the valuation of the company has changed, then such convertibles can become extremely valuable. Convertible arbitrage involves taking long positions in a company’s convertible securities while simultaneously taking a short position in stock futures. It seeks to profit from price inefficiencies of a company’s convertible securities relative to the stock.

6. Arbitrage on relative value

This is a high risk strategy often employed by hedge funds in India and abroad. In India, this is also popularly called pair trading. It takes advantage of perceived price discrepancies between highly correlated investments or deviations from long term mean correlations. Typically, relative value arbitrage strategies involve high risk because it can backfire both ways and losses can magnify. Hence strict stop losses and in-depth expertise is a must.

7. Corporate event driven strategies

These strategies seek to exploit stock price changes that may occur due to specific corporate actions like mergers, takeovers, reorganisations, restructuring, asset sales, spin-offs, dividend declarations etc. Event-driven strategies require expertise in modelling and make extensive use of simulation and artificial intelligence.

8. Quant as a strategy

Quantitative hedge fund strategies rely on quantitative analysis to make investment decisions. Such hedge fund strategies typically utilise technology-based algorithmic to achieve desired investment objectives. Quantitative strategies are often referred to as “black box” funds since investors ordinarily have limited access to investment strategy specifics. Such strategies are normally proprietary and use low latency execution.

9. Global macro strategy

Global macro refers to making investment decisions based on broad political and economic shifts in various countries. This includes bets on shifts in GDP growth, shifts in inflation, changes in interest and yields, major shifts in currency value etc. Classic cases are trades in the financial crisis 2008, European crisis 2011 and Asian crisis 1998.

10. Multi strategy approach

In a nutshell, this is an amalgam of few or many of the above strategies. It offers a lot more flexibility to the hedge fund manager. Multi-strategy funds tend to have low-risk tolerance and lay a lot of emphasis on capital preservation

In reality there are scores of sub-strategies but hedge funds broadly operate within any of the above classifications.
 

What Are the Different Types of Hedge Funds in the Market?

The following lists the four categories of hedge funds:

• Macro Hedge Funds Worldwide: In order to profit from market fluctuations, it makes use of macroeconomic variables as well as financial situations like inflation rates.
• Relative Value Hedge Funds: These funds use the price differential of related securities to generate more advantageous returns.
• Activist Hedge Funds: These funds invest in businesses that address a range of issues, such as asset reorganisation and cost reduction. 
• Equity hedge funds invest in domestic and international equities that, by selling overpriced stocks or even stock indexes, primarily provide protection against declines in the equity market.
   

How are Hedge Funds Taxed?

These funds are classified as AIF category III and are subject to the tax laws governing AIF category III.  Currently, Category III AIF are not regarded as pass-through vehicles. This means that the fund on the whole has to pay a tax when it realises gains or earns revenue in whatever manner.  Stated differently, hedge funds are subject to fund-level taxes. The tax responsibility will not be transferred to investors or unit holders.  

This could be among the factors preventing them from becoming successful in India.  The heavy tax load serves as a disincentive. Before you receive your profits, the taxes are deducted.  This inherently reduces the returns that domestic investors ultimately receive.
 

What are Risk and Return Profile of Hedge Funds?

The points raised above regarding the easing of regulatory restrictions clearly demonstrate the significant level of risk associated with this product. In addition to the significant risk of the underlying securities that top hedge funds participate in, the product is not required by law to register with SEBI or disclose NAV. These two factors ensure that the remaining money are closely monitored and controlled.  This does not imply that SEBI neglects these funds, but it does raise the risk level without any legal obligations. We are all aware of the clear proportionality between risk and return.  Like its dangers, hedge fund returns tend to be higher.  The managers of hedge mutual funds are credited with achieving average yearly returns of up to 15%.
 

Who Should Invest in Hedge Funds?

Hedge funds are often very expensive because they are mutual funds that are managed by professionals.  Those that are financially stable, have extra money, and are willing to take on some risk can easily afford them.

Additionally, you may require the help of a fund manager to manage your hedge funds if you are a novice.  These managers have a high expense ratio, meaning they charge a hefty fee.  Therefore, once you have a lot of experience in the industry or you locate a fund manager you can trust, think about investing in hedge funds.
 

How are Hedge Funds Different from Mutual Funds?

These funds have the same fundamental structure as other mutual funds.  They are an investment vehicle that is pooled.  A fund manager oversees the fund in addition to collecting funds from a group of investors and using them to purchase additional assets.  There are certain distinctions between mutual funds and hedge funds, though.