Hedge Funds. Explained!!

What is Hedge Fund?

Hedge Funds are considered Alternative Investment classes. To hedge means to safeguard, and in the context of investing, it means to protect against risks. Hedge funds pool the money from accredited investors like HNI Clients, Sovereign funds, and other wealthy people and invest in Derivatives like Futures and Options and other Instruments. They need not be registered with SEBI (Securities Exchange Board of India) and need not disclose their NAV periodically like mutual funds. They use the factor called Leverage to make more profits. Hedge funds are risky investments as they invest in different assets, it strives to hedge risks to investors’ money against market ups and downs, and this needs aggressive management. Hedge funds hold both long and short positions and they also hold positions in both listed and unlisted derivatives. Hedge funds use non-traditional and risky investment strategies or asset classes. Hedge funds charge a much higher fees than conventional investment funds and require huge deposits. These hedge funds are registered as Limited Partnership (LP) or Limited Liability Company (LLC). Hedge Funds are managed by Registered Investment Advisor or Money Manager. Hedge funds also invest in arts, stamps, collectibles, paintings, wine, and gold.

Why Hedge Funds?

Hedge funds usually invest for very short term and they invest in risky asset classes and use leverage to multiply the profits. This attracts High Net-worth Individual Clients, wealthy clients, as they have significant assets and they can pay huge fees and can take huge risks to multiply profits. Hence these funds are well-suited to accredited investors. Hedge fund managers are paid based on Fund’s profits which encourages them to take more risks to earn more. Hedge funds also provide investment opportunities in securities, businesses, junk bonds, real estate, and even patents and music copyrights, and they are specialized in these types of investments.

Eligibility for investing in Hedge Funds

For investing in hedge funds, there are some requirements. There are certain income and net-worth requirements to invest in hedge funds.

• If you want to be an Individual accredited investor then you must meet this criterion:

  • You must have a personal net worth of Rs. 7, 50, 00,000, or more, either alone or with a spouse excluding their primary residency.

• If the institutions and entities are accredited investors then they should satisfy the below criterion:

  • You must have a personal net worth of Rs. 7, 50, 00,000, or more, either alone or with a spouse excluding their primary residency.

Characteristics of Hedge Funds

• Hedge funds exclude small investors and they accept money only from QUALIFIED investors – individuals with an annual income that exceeds Rs. 1,50,00,000 for the past two years or a net worth exceeding Rs.7,50,00,000 excluding their primary residence.

• Hedge funds often use leverage or borrowed money to amplify returns and allow them to take aggressive short positions and long positions.

• Hedge funds charge 2% management fees for managing the fund and 20% incentive fees out of the profits generated by fund managers.

Investment Strategies of Hedge Funds

The hedge funds follow some investment strategies. They are:

• Long short Strategy: In this strategy, hedge fund managers take both long and short positions in the stock market. Hedge fund managers analyze the market and enter into long positions in those stocks which they expect the prices would go up and they enter into short positions in those stocks which they expect the prices to fall from further rent market price. So in this way, hedge funds get benefitted from both positions i.e., long and short positions.

• Short only: In this strategy, hedge fund managers take only short positions in the stocks with the help of leverage. So if the market moves in the same direction as they thought, then the hedge fund managers will make a good profit as they have used leverage.

• Macro Strategy: In this strategy, hedge funds analyze how macroeconomic trends will affect interest rates, currencies, commodities, equities around the world and take long or short positions in the asset classes, which they think are most sensitive to the news. Hedge fund managers usually prefer highly liquid instruments such as futures and currency forwards.

• Quantitative Strategy: This strategy involves Quantitative analysis to make Investment Decisions. Quantitative analysis is a technique that tries to understand patterns using mathematical and statistical modeling and research relying on large data sets. Quantitative strategy leverage technology to automatically make trading decisions based on mathematical models. High-Frequency Trading is an example of a Quantitative strategy.

Investment Valuations

There are three levels of Investment Valuations.

• First Level: According to this level, the valuations of an investment can be made by looking at the market price of the security which is listed in the stock market. This type of valuation is useful because the price is publicly available and it is a genuine price. The price of a security is decided by supply and demand in the market for that security.

• Second level: At this level, the valuations of investment are made by looking at the security price of a company that is of the same sector. Ex: If TCS is listed on the stock market and if the fund manager invests in Infosys which is not listed on the stock market, then the fund manager takes the price of TCS, as both companies are from the same industry and decide on the approximate price for Infosys.

• Third Level: At this level, the fund managers neither consider the price of the listed security nor the price of the security from the same industry. At this level, the investment valuations are made based on some assumptions like earnings of the company, recent developments in the company, and some other factors like revenue growth, assets, and liabilities of the company, etc., when we consider this type of valuation, then the valuation may be overvalued or undervalued.

World’s top 5 Hedge Funds by AUM

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