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Hedge Funds: Meaning, Features, Benefits & Taxation Explained

Hedge Funds: Meaning, Features, Benefits & Taxation Explained

Last updated: 27 Nov, 2021 | 04:20 pm

Hedge Funds: Meaning, Features, Benefits & Taxation Explained | INDmoney

“Hedge” means to protect, and in the finance & investing industry, it means to safeguard against unwarranted risks. A hedge fund is a fund that attempts to ‘hedge’ risks by collecting several assets and adopting an aggressive management approach against the investor’s investments during the ups and downs in the market. It is a fund with a portfolio consisting of asset classes like derivatives, equities, bonds, currencies, convertible securities, and now even Cryptos! Thus, we can also regard hedge funds as alternative investments. 

Hedge fund companies in India and around the globe use capital collected from “Accredited investors” like insurance firms, High Net-Worth Individuals (HNIs), banks, endowment funds, and pension funds. A hedge fund quite often incorporated as an overseas investment entity or private investment partnerships. A hedge fund in India does not have to be SEBI registered; they also do not have to disclose their Net Asset Value (NAV) as a routine, unlike the other mutual funds. 

Contrary to a usual equity mutual fund, a hedge fund frequently leans toward using high leverage. These funds take both long and short positions, and also include those in both listed and unlisted markets.

What are the Features of Hedge Funds?

The hedge fund industry in India is relatively young, getting a go-ahead for its functioning only in 2012 when the Securities and Exchange Board of India (SEBI) permitted alternative investments funds (AIFs). These funds have features which are as follows:

  • High net-worth investors

Only accredited or qualified individuals can invest in a hedge fund. These investors are usually banks, high net-worth individuals (HNIs), insurance firms, endowments, and pension funds. The minimum investment that a hedge fund requires from investors investing in these funds is Rs 1 crore.

  • Diverse portfolio

Hedge funds often build a comprehensive folio of investments, including currencies, derivatives, stocks, real estate, equities, bonds, and even cryptos. You guessed it right; they generally cover all the asset classes capable of providing a hedge to other portfolio components generating returns.

  • Higher fees

These funds earn from the concept of both expense ratio and management fee. The global standard for this is Two/Twenty, which means a 2% fixed management fee and a 20% fee on the profits earned. For hedge fund companies in India, the management fee can be below 2% to 1%. And the profit-sharing can be between 10% to 15%, barring the top funds in India. 

  • Higher risks

Hedge funds investment techniques can lead the fund to huge losses. Lock-in periods are generally long for investments. Credits used by these funds can turn investments into considerable losses.  

  • Taxation

The Category III AIF or the hedge funds in India are still not given synonymous status on tax. This aspect means that the income of these funds is taxable at the appropriate investment level. And it also signifies that the taxation will not pass through to the hedge fund investors. This feature becomes a demerit for the industry as they don’t have the other mutual funds’ advantage. 

  • Regulations

The hedge fund companies in India don’t need to register with the securities markets regulator (SEBI). They also don’t have other routine reporting mandates, including the regular disclosure of Net Asset Value.

How do Hedge Funds Work?

Returns from hedge funds are purely to the merit of the fund manager and their skill, instead of the market conditions. 

Fund managers try their best to reduce or even remove market exposure and generate market-beating returns despite the market fluctuations. They operate in smaller market segments to reduce their risk of the unknown by more diversification. 

Some more strategies that the hedge fund managers implement are as follows:

  • Short selling: In this, the fund manager, betting on the prices to drop, can sell shares to buy back in the future at a lesser price.
  • Use arbitrage: Many times the securities have inefficient or contradictory pricing. Managers use this opportunity to make their bets.
  • Invest in an upcoming event: Significant market events, such as mergers, acquisitions, and spin-offs, can affect a manager’s investment strategy.
  • Investing in securities with deep discounts: Some companies with financial difficulties or even facing insolvency issues will have their securities at low prices. The manager can choose to buy the particular security after learning the possibilities.  

Types of Hedge Funds in the Market

  • Domestic hedge funds: Investors belonging to the original country’s taxation have access to domestic hedge funds. 
  • Offshore hedge funds: Hedge funds forming outside the boundaries of one’s own country, most probably in a low taxation country, are called offshore hedge funds.
  • Fund of funds: This type refers to mutual funds investing in other hedge funds instead of investing in the individual underlying security. 

Benefits of Hedge Funds: 

As discussed above, the relaxation of regulatory requirements significantly affects the high risk associated with hedge funds in general.

Other than the fact that the securities in the portfolio of the top hedge funds in India carry high risk, these funds are legally not bound for a SEBI affiliation or even the regular disclosure of their Net Asset Values. These points keep the funds under close watch and are closely regulated. 

Therefore, for a person to know how to start a hedge fund company in India, it is necessary to know these facts entailing the current existence of the industry. Since risk and returns are directly proportional, a hedge fund’s returns, just like the risks, are usually on the higher side and thus preferred by the institutions. Generally, the average annual returns can be as high as 20%, the merits of which rest with the hedge fund managers.

Taxation on Hedge Funds

The hedge funds falling under the AIF (category III) will be liable to taxation as per the taxation rules applicable to the category. 

AIF (Category III), currently, is not part of the pass-through vehicles. As a result, it is clear that whenever there is any booking of gain/income realization in any form on the hedge mutual funds, there is taxation on the fund level. In such a case, the investors or the unitholders will not have to face any tax liability. 

One of the main reasons the concept of hedge funds has not risen as expected in India is the high tax burden, which acts as a resistance. It happens so that the tax is realized way before the distribution of profits to the investors. This aspect is one of the primary reasons for the effect on domestic investors as it curbs the return metrics. 

Difference between Hedge Funds and Mutual Funds

  • Investment approach: Hedge funds usually have an aggressive approach on their investment bets and seek higher returns on capital invested, sometimes using speculative positions and trading in derivatives like futures and options. They can take short positions or sell short in the markets, while a typical mutual fund cannot. Short selling enables these funds to generate returns even in falling markets, which is not the case for mutual funds. 
  • Leverage: Mutual funds are comparatively straightforward and safer as they don’t carry much leverage. On the other hand, hedge funds have considerable leverage, and thus, carry higher risk while generating higher returns.
  • Investors: Hedge funds are vehicles only available to high net-worth investors. In contrast, mutual funds are open to a large group of ordinary people. In a mutual fund, you can start a simple SIP with an amount as low as Rs. 500.  On the contrary, hedge funds are high-risk funds that the public at large cannot bear; these funds aim at higher returns for HNIs in return for a big size check with different levels of sophistication and adjustments compared to mutual funds. 

Things to Keep in Mind Before Investing in Hedge Mutual Funds

  • The complexity of products: Due to the high complexity of investing in this type of fund, an investor needs to be completely prepared and ready to conduct thorough research. Apart from the study, there is a need to monitor the investment continuously.  A hedge fund is in short-selling and trading in derivatives. Since this type of trading demands a good amount of capital investment, investors generally having large sums of money at their disposal prefer hedge funds. 
  • Risk factors: A low level of regulation hikes up the risk factor to a greater extent, apart from the primary risk attached to playing in derivatives. SEBI does not mandate hedge mutual funds to register under them as a regulator, so hedge mutual funds and hedge funds with their investors are on their own. 
  • Fee and costs: It is not feasible for an average investor to fulfill the minimum investment criteria of Rs. 1 crore for a single investment. It does not fit into the category of their feasibility which could be touted as a good strategy. 
  • Returns and volatility: Hedge fund performance is volatile, so one needs to be prepared for the dips but can also expect huge upsides.

Final Thoughts

Hedge mutual funds are usually intricate in their functioning and complex in their structure and strategy. They can invest in almost every possible asset, so they are largely diversified and have the potential to generate enormous value for their investors. 

However, strategies on arbitrage and long/short selling can sometimes become high on the risk side. It is advisable to form a base foundation strategy and understand the risk appetite to safeguard the investments from unnecessary losses. 

From an investment point of view, explore these funds only if they are in line with your goals, and make sure to do your due diligence and research before going ahead and making a considerable investment. If you play your cards well, you can derive substantial benefits from this form of investment. 

FAQ’s

  • Are hedge funds a safe buy?

Hedge funds are inherently riskier investments than other alternatives because they often place bets on investments trying to get huge, short-term gains. These bets can even be with money borrowed from brokers, banks, and other financial institutions. But these bets can even lead to losses. Hedge funds opt for these risky strategies to produce returns irrespective of the market conditions.

  • Are hedge funds regulated?

Securities and Exchange Board of India (SEBI) is a regulator for hedge funds in India. Securities and Exchange Board of India for Alternative Investment Funds Regulations, 2012 was implemented in 2012 to regulate all Alternative Investment Funds (AIFs).

  • Are hedge funds legal in India?

Hedge funds in India do not need to compulsorily register with the Securities and Exchange Board of India (SEBI), the market regulator. Nor do they have to publicly disclose their NAVs or the Net Asset Value at the end of the day. Thus, although they are legal, hedge funds in India do not have to follow the regulatory requirements expected from all the other mutual fund companies.

  • Can hedge funds be sold to the public?

Hedge funds often allow only wealthy people or HNIs to invest in them due to the inherent risks associated with the investments. These funds include many asset classes, such as real estate, equities, or entire firms. Accredited investors must have an income of at least ₹2 Cr for the previous years or a net worth of over ₹7.5 Cr.

  • How do hedge funds use leverage?

Hedge funds use different forms of leverage to gain huge returns. They can purchase the securities on margin, which means they can use a broker’s money to make larger investments. Leverage often allows hedge funds to bet big and make potentially huge returns on their investments. But this strategy can also fail, amplify losses, and increase the risk of failure if the bets go against them.