Last updated: 27 Nov, 2021 | 04:20 pm
“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:
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.
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.
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.
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.
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.
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:
Types of Hedge Funds in the Market
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
Things to Keep in Mind Before Investing in Hedge Mutual Funds
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
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.
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).
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.
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.
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.