What is a Hedge Fund?

Introduction

Investment in the stock market involves risk depending on the instrument/s used. These risks occur due to market volatility, uncertain business environment, and sudden unforeseen events. The risk becomes higher if the quantum of investment is high. To reduce or mitigate the risks and to increase returns, institutional and high net worth investors invest in Hedge Funds.

This article discusses the hedge funds definition, how a hedge fund works, and the types of hedge funds.

What are hedge funds?

Hedge fund meaning a pool of investments made by specific entities to earn higher profit using alternative or complex investment strategies. These funds are instruments used to reduce risk or make higher profits by actioning unconventional strategies and modes of investment.

The hedge fund manager invests aggressively using methods like taking long and short positions in the stock market, buying and selling equities, arbitrage, trading bonds, currencies, derivatives, securities commodities, etc. This way, they can invest in a wide range of asset classes without meeting any rigid constraints in the timing of investments.

But how do hedge funds work? Hedge funds work as private investment partnerships or offshore investment corporations. They need not be registered with the securities market regulators and are not required to make periodic disclosures. The investors are usually high-net-worth individuals, family endowments, pensions, insurance companies, and banks who pool their money to create a fund managed by a fund manager.

These funds are not regulated as closely as mutual funds and hence include a high risk. Due to this risk, entities investing in hedge funds tend to be wealthier than regular investors.

How are Hedge Funds categorised?

Hedge funds are categorised based on the strategies used by the fund manager. There can also be multiple strategies at play for a fund depending on the risk management, diversification, or flexibility to meet the risk and returns profile of the fund. The information and critical aspects of these strategies are explained in the hedge fund's prospectus for potential investors.

The four categories are Global macro, directional, event-driven, and relative value.

Global Macro

This strategy uses analysis of major economic patterns globally to profit from their price movements. The fund manager invests majorly into shares, bonds, and currency markets influenced by significant macroeconomic events, and, identifies opportunities to earn profits. This strategy offers considerable diversity and flexibility, allowing participation in multiple markets.

However, the timing of implementation is essential to earn high returns. Global macro strategy is divided into discretionary and systemic trading. In discretionary trading, the fund manager selects investments based on analysis, while in the systemic method, they use computer models and programs.

Directional

In a Directional investment strategy, the fund managers use the market movements, trends, and gaps across different markets to pick stocks and securities. These stocks have greater exposure to market fluctuations and have further sub-categories that focus on groups of similar shares. For example, “Emerging market funds” focus on markets like China and India, and “sector funds” focus on specific sectors like technology, pharma, etc.

Event-driven

Major corporate events like acquisitions, recapitalisations, bankruptcies, and liquidations present an opportunity for hedge fund managers to capitalise on valuation inconsistencies after predicting the movement of the related securities. Large institutional investors who participate in hedge funds have the resources to analyse such transactions and take profitable positions.

Relative Value

The relative value strategy uses price discrepancies in securities to its advantage. Hedge fund managers use mathematical, technical, and fundamental techniques to identify price discrepancies in securities.

History of Hedge Fund

Alfred Winslow Jones is known to have created the first hedge fund strategy. He sought to neutralise two risks, first, by investing in stocks that would perform better than the overall market, and second by selling short assets whose prices were expected to decrease.

The market performance posed the first risk, while the second was the performance of the individual assets. Hence, his portfolio was ‘hedged’ against the risks of the market movements. Jones thus created the first hedge fund product in 1952 as a limited partnership with a 20% fee.

Many investment enthusiasts established new hedge funds following the outperformance of Jones’s fund. Fund managers created a fund of many hedge funds in 1969 for interested investors.

The hedge fund market suffered a severe crash after the 1973-74 crash. It resurged in the 1980s and boomed in the 1990s, during which fund managers launched many dominant hedge funds. They moved into the mainstream in the 2000s, during which pension funds and insurance companies made their first investments. Post-2008 market crisis, hedge funds were regulated. Today the assets under the management of hedge funds worldwide are worth about 3 trillion dollars.

Key characteristics of Hedge Fund

These funds have some key differences from other pooled investments.

1. Qualification: Only accredited investors are allowed to participate in Hedge Funds. These investors “qualify” only if they can invest a minimum amount of Rs 1 crore and the number of investors cannot cross 1000. The minimum pool of funds required to start a hedge fund is Rs 20 crore.
    
2. Lock-in period: Hedge funds have a lock-in period of 1 year. The withdrawals are restricted to bi-monthly or quarterly depending on the scheme.
    
3. Fees: The fee structure is denoted as “1 and 10 -15”.  The fund manager is entitled to 1% of the total assets under management at the start or end of the year. They also earn 10 to 15% of the total profits earned by the fund throughout the year. Hedge Funds in the West have a different fee structure known as the “Two and Twenty”, where a 2% fee is calculated as 2% of the total assets of the company and 20% of the gains generated.
    
4. Strategy: Hedge Fund managers can invest in any asset class they deem profitable, including land, real estate, equity, derivatives, and currencies. However, they must follow the guidelines laid down by SEBI for Hedge Funds.

Can I invest in Hedge Funds?

Only qualified or accredited investors can invest in Hedge Funds. The minimum ticket size for the investment is Rs 1 crore. Generally, High Net worth individuals (HNI) and institutional investors like banks, insurance companies, pension funds, endowments, etc. invest in Hedge funds. Even if you have surplus funds, you must know that a high-risk appetite is a prerequisite while investing in hedge funds. The fund manager must invest aggressively at high speeds to keep up with the fast-paced market changes.

High risk translates to a high expense ratio. This logic implies that the pay-out to the fund manager is in the range of 15% to 20% of your returns apart from the fees of 1% of assets managed per year. Also, you must be able to trust the Fund Manager with such a high risk for your wealth.

So unless you have considerable experience in investments in the capital markets it is advisable not to venture into Hedge Funds.

Benefits Vs Risks

Benefits

1. Hedge funds allow for a wide range of investment strategies with multiple asset classes.
2. They allow diversification of an investment portfolio to profit from many different markets. One can book profits in both a bullish and a bearish market.
3. They can feed on the prowess of talented fund managers to get higher returns.

Risks

1. Lock-in periods may restrict access to liquidity.
2. Dependance on the strategy of a fund manager can be risky if they fail to deliver.
3. The quantum of wealth is high, which can cause stress on personal investment strategy.

Things to remember

1. It is necessary to study and understand the fund prospectus properly, as the strategies involved in hedge funds vary significantly from other investment instruments.
2. There are many different hedge funds in the market. The decision to invest should be an informed one.
3. Fund managers may sometime charge high fees, which may not be on par with the returns. It is necessary to research and investigate the company and the fund manager.