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Hedge Funds In India Research Team | Posted On Monday, October 22,2018, 03:16 PM

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Hedge Funds In India



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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Hedge Funds In India

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.

1. How does a hedge fund work?

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.

Arbitrage: The simultaneous buying and selling of securities in different markets to make a profit. You can buy and sell in the NSE and BSE to make a profit.

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.

2. Structure of a hedge fund:

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%.

Term structure:

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.

3. What is a “2” and “20”?

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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4. Different Types of hedge funds

  • Market-neutral funds: Market neutral funds are used to hedge/protect against market movements. They have the same amount of exposure to bullish and bearish positions.
  • Convertible arbitrage funds: The hedge fund buys convertible securities like convertible bonds and converts then to common stock. The common stock is short sold.
  • Event driven funds: Certain events like corporate actions or political developments may have an impact on the market prices of shares. The hedge manager looks to profit from price inefficiencies to make profits.
  • Macro funds: Macro funds invest in bonds, currencies, stocks and commodities. They are extremely risky.
  • Distressed securities funds: Some Company shares would be really cheap as they accumulate large debt or face potential bankruptcy. These Companies are in financial distress and shares are cheap. If the Company collapses into bankruptcy, the shares are worthless.
  • Emerging market funds: These invest in developing economies with low to medium per-capita income.
  • Long-only funds: Long-only funds focus only on long positions (buying) with the hope of profiting from an increase in price. In a bearish market, they could collapse.
  • Short-only funds: They look for bearish markets to short sell stocks. They are risky as if markets move in opposite directions, they could be heavy losses.
  • Fixed-income arbitrage funds: These take advantage of price differences in fixed income securities like bonds, treasury bills and CDS (Credit default swaps). In CDS the buyer acquires corporate or sovereign debt through bonds. The issuer insures the buyer’s potential losses (risk of default) as part of the deal.
  • Merger arbitrage funds: The fund sells stocks of Companies undergoing a merger. The target Companies shares generally rise and the acquirers shares generally fall.   

5. Difference between hedge funds and mutual funds:

  • Hedge funds have increased leverage and take speculative positions in derivatives. There’s no leverage in equity mutual funds.
  • Hedge fund managers are flexible. The mutual fund manager sticks to a strategy.
  • The mutual fund enjoys high liquidity (you can withdraw at anytime). Hedge funds have a lock-in for subscriptions and redemptions.
  • The mutual fund may be benchmarked to an index. The hedge fund looks for absolute returns.
  • The hedge fund manager has skin in the game. He puts his money in the fund. The mutual fund manager doesn’t face this problem.

6. How to invest in a hedge fund?

  • If you have experience investing in stocks and fixed income securities, try hedge funds.
  • Read the hedge funds prospectus carefully.
  • Understand the expense ratio and fees involved.
  • Understand the lock-in vis-à-vis subscriptions and redemptions.
  • Do your research on the hedge fund manager.

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