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Hedge Funds: Understanding their Role in India

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A particular kind of mutual fund known as a hedge fund as it constituted a private investment limited partnership. Confused? This item is a little complicated.

The Securities and Exchange Board of India (Sebi) states that “Hedge funds, including fund of funds, are unregistered private investment partnerships, funds, or pools that may invest in and trade in many different markets, strategies, and instruments (including securities, non-securities, and derivatives), and are not subject to the same regulatory requirements as mutual funds.”

Hedge funds come in several varieties based on the securities they invest in and the sorts of management methods they employ.

No matter how the market performs, this kind of investment is made to provide profits. As a result, some claim that hedge funds are immune to market pressures, yet performance research suggests that this may not be the case.

Why Are They Called Hedge Funds?

Financial hedging may be compared to growing garden hedges since both establish a barrier, often for security and privacy and are an alternative to traditional fencing. In finance, hedging refers to limiting or reducing risk exposure in an effort to increase the security and success of an investment despite volatile markets. Hedge funds will use various financial tools or market tactics to reduce risk. The theory is that by diversifying the investments in their investment portfolio, people reduce risk by reducing their reliance on a single asset type.

How Do Hedge Funds Operate? 

Hedge funds employ various trading strategies based on the diverse range of securities and assets in which they invest. Their portfolio includes equities, debt, and derivatives, such as futures and options. These strategies encompass activities in public stock markets or direct investments through private placements.

For instance, futures grant the right or obligation to buy/sell an underlying stock at a predetermined price, date, and time. Options offer similar trading opportunities without the obligation. Such securities inherently introduce a mix of trading techniques, enhancing diversification.

Hedge mutual funds gather capital from larger investors—such as high-net-worth individuals, banks, endowments, pension funds, and commercial firms. Classified as Alternative Investment Funds (AIF) Category III, they deploy these pooled funds to invest across global and domestic markets.

The scope of hedge mutual fund investments is extensive, encompassing equities, bonds, real estate, currencies, convertible securities, and derivatives, among other assets.

How Hedge Funds Work? 

Hedge funds operate uniquely in India, targeting accredited investors who meet specific financial criteria. To qualify as an accredited investor, an individual should possess a liquid net worth exceeding ₹7 crore or an annual net income surpassing ₹15 lakh (or ₹20 lakh with a spouse). This criterion ensures that investors with substantial financial knowledge and capability are involved.

Structured as limited partnerships, hedge funds consist of two key roles: limited partners (the investors) and a general partner (the hedge fund company). By pooling resources from limited partners, the hedge fund undertakes investment activities on their behalf.

By focusing on accredited investors, hedge funds in India can employ more dynamic investment strategies. Unlike mutual funds, they face less stringent regulation from regulatory bodies such as SEBI. This flexibility empowers fund managers to explore advanced tactics, including leveraging, short-selling, and utilizing derivatives like options. Additionally, hedge funds can diversify across a wide array of markets, spanning stocks, bonds, commodities, real estate, cryptocurrencies, and more. They essentially explore various avenues for potential profit.

Investing in hedge funds in India may involve some limitations in liquidity. Investors are typically allowed to enter or exit during specific periods, often accompanied by a lock-in duration ranging from several months to a few years after the initial investment. This approach empowers fund managers to pursue more aggressive investment positions without the constant need to provide immediate liquidity to investors.

Key Characteristics of Hedge Funds

Hedge funds exhibit distinct traits that set them apart from other pooled investments, making them an intriguing choice for certain investors.

Qualification and Investor Limitations: Participation in Hedge Funds is exclusively available to accredited investors. To be eligible, investors must meet specific criteria, including a minimum investment of Rs 1 crore. The total number of investors is also capped at 1000, ensuring a focused and exclusive pool. A minimum pool size of Rs 20 crore is required to initiate a hedge fund, emphasizing a substantial commitment.

Lock-in Period and Withdrawal: Hedge funds impose a mandatory lock-in period of one year, enhancing stability and commitment. Withdrawals are further subject to bi-monthly or quarterly restrictions, depending on the chosen scheme. This approach safeguards the fund’s strategy execution and maintains a balanced investor base.

Fee Structure: The fee structure, referred to as “1 and 10-15,” outlines compensation for fund managers. They receive 1% of the total assets managed at the beginning or end of the year. Additionally, they earn a share of profits, typically ranging from 10% to 15%, generated by the fund during the year. This fee model contrasts with the Western “Two and Twenty,” comprising a 2% fee based on total assets and a 20% share of gains.

Investment Strategy: Hedge fund managers possess the flexibility to invest across diverse asset classes, encompassing real estate, equity, derivatives, and currencies. While leveraging this freedom, adherence to SEBI guidelines is mandatory, ensuring a regulated investment approach.

Investing in Hedge Funds

Eligibility and Risk Considerations: Hedge funds are accessible solely to qualified investors, requiring a substantial minimum investment of Rs 1 crore. High Net Worth Individuals (HNIs) and institutional investors, including banks, insurance companies, and pension funds, often engage in hedge fund investments. However, potential investors must possess a robust risk appetite due to the inherent high-risk nature of these investments.

Risk and Return Dynamics: The high-risk nature of hedge funds corresponds to an elevated expense ratio. Typically, fund managers receive 15% to 20% of returns in addition to the 1% annual asset management fee. This compensation reflects the intensive approach required to navigate swiftly changing market conditions.

Benefits and Risks of Hedge Funds

Hedge funds are like a toolbox with many different tools to help your money grow. They can invest in different things like stocks, land, and more. This can strengthen your investments, even when the market is doing well or not. When smart fund managers handle your money, you have a better chance of getting more back.

Hedge funds have some tricky parts too. They might keep your money locked up for a while, which means you can’t use it when you want. Depending too much on what the fund manager decides can be risky. If they make mistakes, your money might not grow. Also, having a lot of money invested could make you worry a lot about how it’s doing.

Remember, while hedge funds can be helpful, they also come with some challenges. It’s important to think about both the good and not-so-good parts before deciding if they’re right for you.

Key Points to Remember When Investing in Hedge Funds

1. Understand the Information: Before investing, take the time to understand the document explaining how the hedge fund works. Hedge funds are different from other ways of investing, so it’s important to know what you’re getting into.

2. Different Choices, Be Careful: Many types of hedge funds exist. Before you decide to invest your money, make sure you learn about them and pick the one that fits your needs.

3. Watch Out for Costs: Hedge funds can have higher fees. Think about whether the possible extra money you might earn is worth these fees. Also, do your homework on the company that runs the fund and the person who manages it.

4. Make Smart Choices: By learning about these important things, you can make smart choices when you’re thinking about investing in hedge funds. It’s all about making informed decisions that are best for you.

Conclusion

Hedge funds offer diverse strategies to support investments in challenging markets. However, they come with risks such as lock-in periods, dependency on fund managers, and managing significant wealth levels. Before investing, carefully study the prospectus, choose wisely among options, and carefully assess the fee structure and fund manager’s track record. Share India trading app is a reliable partner for investors considering hedge funds, offering a user-friendly interface and expert insights. Explore the world of hedge funds cautiously with the right knowledge and a trustworthy ally by your side.

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