Hedge funds hold out the promise of large rewards but are also risky
Source: Tavaga Research
The history of hedge funds can be back to 1949 when a sociologist and former writer Alfred Winslow Jones’ company launched the first hedge fund. So, what are they really?
Hedge fund meaning
The answer to the question, ‘What is a hedge fund in simple terms’, is this: It is a pool of funds making investments in illiquid investments using unconventional strategies.
What exactly does a Hedge Fund do?
In a hedge fund, the fund manager pools money from investors (partners or shareholders) and uses various unconventional strategies to earn profits. Hedge funds are set up as LLCs (limited liability companies) or LLPs (limited liability partnerships) where the liabilities of the partners and fund manager are limited.
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Hedge funds in India
Hedge funds in India are categorised under alternative investment funds (AIFs) as defined by Sebi.
An alternative investment is one different from traditional long-only positions in stocks, bonds and cash.
While it may sound complicated, we should remember that investments in assets such as commodities and real estate that many of us may be familiar with, are also considered as alternative investments by Sebi.
To understand hedge funds in India better, we should appraise ourselves with what Sebi means by an AIF and its three categories.
In a May, 2012 circular, Sebi classified alternative investments into three categories. They are:-
(a) Category I — Comprises AIFs which invest in start-up or early-stage ventures, social ventures, SMEs (small, medium enterprises), infrastructure or other sectors or areas which the government or regulators consider as socially or economically
desirable. It shall include venture capital funds, SME Funds, social venture funds, infrastructure funds and such other alternative investment funds as may be specified.
For our understanding, those AIFs which are perceived to have a positive spillover effect on the economy. These are the funds for which Sebi, the Government of India or other Indian regulators may consider providing incentives or concessions.
(b) Category II — AIFs which don’t fall in Category I and III, and which don’t undertake leverage or borrowing other than to meet daily operational requirements, and as permitted in Sebi’s regulations.
So, AIFs such as private equity funds or debt funds for which no specific incentives or
concessions are given by the government or any other regulator are included.
(c) Category III — AIFs that employ diverse or complex trading strategies, which may employ leverage through investment in listed or unlisted derivatives.
Hedge funds, funds which trade with a view to make short-term returns or funds which are open-ended and for which no specific incentives or concessions are given by the government or other regulators are included.
While our interest is in hedge funds today, there is no universal definition for them in securities laws.
Instead, hedge funds are identified with the help of their most common characteristics. Some of them are:-
- Investment requirement: The minimum investment requirement in hedge funds is Rs 1 crore and the maximum number of investors is limited to 1,000. Also, the minimum pool of funds required to start a hedge fund is Rs 20 crores.
- Lockup period: Hedge funds usually have a lock-in period of one year. There is also a restriction on withdrawal of funds. For example, funds may only be withdrawn bi-monthly or quarterly, depending upon the scheme.
- Fee structure: Usually the fee structure is “1 and 10-15”, which means the fund manager is entitled to a 1 percent fee on the total asset under management, either at the start of the year or at the end of the year, and a 10-15 percent of the total profits generated throughout the year. In the west, the fee structure is “2 and 20”.
- Performance measurement: The performance of hedge funds is not measured against a benchmark or index. Because of this feature, these funds are also known as “absolute return” products (as there is no relative returns to compare with).
- Regulatory requirement: SEBI lays down guidelines for regulation of hedge funds.
Types of hedge funds
Rather than types of hedge funds, the types of strategies they deploy that differentiate one from the other. The different strategies determine how a hedge fund makes money.
Some of the most commonly-used hedge fund strategies are:
- Event-driven strategies The main aim of event-driven strategies is to generate profit from short-term events. Long and short positions are taken in all types of securities including derivatives. Further subdivisions include:-
- Merger arbitrage: Whenever a company merges with another, the acquired trades at a discount. This strategy involves taking a long position in the stocks of the company being acquired and taking a short position in the stocks of the acquiring company. The reason being the acquirer may overpay and suffer from the increased debt-load. The risk that the fund manager bears is that if the announced merger does not take place and they don’t close the arbitrage on time.
- Activist shareholders: The focus of this strategy is to purchase enough equity stocks in order to influence a company’s direction or policies. Here, the hedge fund becomes the majority shareholder and may advocate for change in management and company strategy, restructuring and divestitures.
- Special situations: The focus of this strategy is to look for the opportunities in the equity of those companies which are involved in restructuring activities apart from mergers/acquisitions and bankruptcy. These activities include asset sales/spin-offs, special capital distributions, and repurchase/ issuance of security.
- Relative value strategies These seek to profit from an unusual short-term price discrepancy between related securities. These strategies are also called arbitrage strategies as they aim to exploit the mismatched price in the markets among similar asset classes. Suppose in the case of two large private sector banks, both being in the same space would have similar operational risks. Based on this info, it may be assumed that their market performance would be correlated, if we leave aside the company-related factors. But if a hedge fund manager notices a discrepancy in their returns compared to their historic long-term average price, when there is no company-related factor at play, then there will be a move to make. Suppose one bank’s stock is moving above the long-term average mean price and the other’s falling. The hedge fund manager would then be choosing the relative value strategy to go long on the bank’s stock that is falling and short on the one whose stock is rising, till they revert to their mean price.
This is also called pair-trading in trading parlance.
- Equity hedge strategies
The focus of equity hedge strategies is to take long and short positions in equity and equity derived securities. Some of the most commonly-used equity hedge securities are:
Market neutral: These strategies use fundamental and/or technical (quantitative) analysis to identify overvalued and undervalued securities. The fund manager takes a short position in overvalued securities and a long position in undervalued securities. The aim is to maintain a net neutral position with respect to market risk.
Fundamental growth: The aim of this strategy is to identify those companies which are poised to exhibit high growth and capital appreciation. The fund manager takes a long position in such stocks.
Fundamental value: The aim of the fund manager is to keep looking for undervalued stocks and identify them. It is done using fundamental analysis. The fund managers take a long position in those stocks.
Quantitative directional: The fund manager uses technical analysis to identify overvalued and undervalued stocks. Short positions are taken in the overvalued companies and long positions are taken in the undervalued companies. The aim of this strategy is to remain net long or net short, depending upon the direction of the market.
Short bias: The aim of the fund manager is to identify overvalued equity securities with the help of fundamental and/or technical analysis. Overall, the fund manager maintains net short positions upto the degree of decline expected.
Sector-specific: The aim of this strategy is to explore securities sector wise, using quantitative (technical) and fundamental analysis.
- Macro strategies This strategy involves a “top-down” approach to identify economic trends around the world. The process begins with analysing the macro-economic variables and ends with the analysis of a particular security. The securities used for trading are commodities, equity, currency and fixed income. To generate profit, the fund manager takes long and short positions in the direction of the market being influenced by major economic events.
Advantages of investing in hedge funds
Some of the benefits of investing in hedge funds include alignment of interest between the investors and the fund manager, flexibility and aggressive investment strategy.
Hedge funds are structured in such a way that it aligns the interest of the fund manager and the investors, with provisions such as high watermark.
The high watermark provision is one which allows the fund manager to get compensated for his performance only if the fund crosses a certain watermark.
Let us suppose the Nav of the fund in the starting year is Rs 1,000, the next year, it went to Rs 3,000, and in the third year, it fell to Rs 1,700. Now, the high watermark provision may state that the fund manager will only get their performance fees (incentive fees) in year four if and when the fund crosses the Rs-3,000-level watermark. This aligns the interest of the manager with that of the investor to target new achievements.
Hedge funds vs mutual funds
A hedge fund is different from a mutual fund. Mutual funds raise money from the general public, while hedge funds raise from HNIs or UHNIs, with large ticket sizes compared to retail investors’ portfolios with MFs.
Mutual fund managers are barred from taking a profit-sharing cut, which we call performance fees. But this is a common practice in hedge funds.
Since there is the retail public involved, the MF industry is heavily regulated with respect to investment in securities, whereas hedge funds are not as strictly regulated as MFs. Hence, retail investors should steer clear of hedge funds, given their risky nature.