What do you understand by the word hedge? Hedge means to avoid and is this context we mean to avoid risk. A hedge fund uses money collected from banks, insurers, HNIs, families and pension funds. It functions as an overseas investment corporation or a private investment partnership. What’s the main difference between a hedge fund and a mutual fund? A hedge fund doesn’t need to be registered with SEBI and it doesn’t have to disclose NAV periodically like a mutual fund.
A hedge fund is also called an alternative investment fund or AIF in India. The hedge fund portfolio has asset classes like equities, derivatives, bonds, currencies and even convertible securities. A hedge fund needs an aggressive portfolio manager as it takes big risks. A hedge fund is different from an equity mutual fund as it takes up a lot of leverage or debt. A hedge fund has long and short positions (buy/sell positions), in listed and unlisted derivatives.
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Should you invest in a hedge fund? A hedge fund is managed by expert professional managers and tends to be expensive. A hedge fund is for someone who has lots of money and is very aggressive. The hedge fund manager takes a lot of risks, buying and selling derivatives/assets at lightning speed. A hedge fund has a high expense ratio and can eat up 15-20% of your returns. If you are a first time investor, it’s wise to stay far away from hedge funds.
Let’s understand how a hedge fund works with an example. You set up a Company called XYZ Ltd as a limited liability Company or LLC. According to the operating agreement which is a legal document stating how a Company is managed and also that you will receive 20% of any profits over 5% a year. You can invest in anything like stocks, bonds, derivatives, office space, wine, antiquities, real estate, startups, rare art, stamps, diamonds, gold or even wine. Simply put, you can invest in anything that makes money.
Now an investor puts Rs 100 Crores in your hedge fund. The money is put in the brokerage account and deployed as per the operating agreement. You can invest the money in an office space, startup, co-working space or pretty much anything.
You have doubled the investment from Rs 100 Crores to Rs 200 Crores in a year (this is a profit of Rs 100 Crores), through some spectacular investments. According to the operating agreement, the first 5% belongs to the client. This means out of Rs 100 Crores, the client gets Rs 5 Crores. Anything above this amount is split 20% and 80%. This means out of the Rs 100 Crores, a sum of Rs 5 Crores goes to the client. Out of the remaining Rs 95 Crores, the client gets 80% which is Rs 76 Crores. You get to keep Rs 19 Crores. The more profits you make for the client, the more money you get to keep. The client walks away with a cool 81 Crores.
The common ways hedge funds make money:
Short selling: The fund manager believes share prices will drop and sell shares with a buy-back in the future at a lower price.
Making use of an upcoming event: There may be a merger, acquisition or a spinoff and the manager could make a profit.
Look for a distress sale: Some Companies may be in deep distress or near bankruptcy and their shares fall. The fund manager after weighing the pros and cons makes a purchase. If the Company turns around, the fund manager makes a tidy profit.
General Partner: The general/limited partnership is the most common structure vis-à-vis hedge funds. In this form, the general partner is responsible for the functioning of the fund. The limited partner is liable only for his/her paid-in amounts as he makes investments into the partnership.
Structure of the partnership: The typical structure is a limited liability Company. The general partner manages the fund, appoints the fund manager, and manages the administration of the fund.
Fee structure of the fund: The fee structure is much higher than mutual funds. A fund manager makes a lot of money and a hedge fund has a high expense ratio.
Management fee: The hedge fund charges a management fee of 2% of the assets.
Incentives: Hedge funds have incentive fees of around 20% of the profits and in some cases even 50%.
Redemptions: There’s no daily liquidity but some hedge funds have monthly subscriptions and redemptions, while some have quarterly redemptions.
Lock up: Some hedge funds have a one to two year lock up.
This is how fund managers make the money. You have what is called “2” and “20”. The hedge fund manager charges a flat 2% fees on the total asset value. There’s an additional 20% profit fee on the profits earned. The hedge fund manager gets the 2% management fees, regardless of the performance of the fund. The 20% profit is paid only once a certain profit threshold is achieved.
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