Who should invest in Hedge Funds & its Benefits?
Hedge funds are still at an initial phase and are not as widely known as
other mutual funds. Though they too pool investments from various
investors, they use highly complex strategies to ‘hedge’ risks and
deliver high returns. In this article, we will sum up everything about
hedge funds and trace its rising popularity in India.
What are Hedge Funds?
To hedge means to safeguard, and in the context of investing, it
means to protect against risks. A hedge fund uses the funds collected
from accredited investors like banks, insurance firms, High Net-Worth
Individuals (HNIs) & families, and endowments and pension funds.
This is the reason why these funds often function as overseas investment
corporations or private investment partnerships. They do not need to be
registered with SEBI, nor do they need to disclose their NAV
periodically like other mutual funds.
A hedge fund portfolio consists of asset classes such as derivatives, equities,
bonds, currencies, and convertible securities. Hence, they are also
considered as alternative investments. As a collection of assets that
strives to ‘hedge’ risks to investor’s money against market ups and
downs, they need aggressive management. Unlike the typical equity mutual fund,
they tend to employ substantial leverage. They hold both long and short
positions, including positions in listed and unlisted derivatives.
Who should invest in Hedge Funds?
Hedge funds are mutual funds that are privately managed by experts.
For this reason, they tend to be a bit on the costlier side. Hence, they
are affordable and feasible only for the financially well-off. You not
only have to be someone with surplus funds, but also an aggressive
risk-seeker, this is because the manager buys and sells assets at
dizzying speed to keep up with the market movements.
As you know, higher the structural complexity, more the risks. Hence,
the expense ratio (fee to the fund manager) is way more for hedge funds
than regular mutual funds. It can range from 15% to 20% of your
returns. So, we recommend first-time depositors to steer clear from
these funds until you gain considerable experience in the field.
Even then, it all depends on the fund manager. Therefore, unless you
have full faith in your fund manager, investing in hedge funds can give
you sleepless nights.
What are the Features & Benefits of Hedge Funds?
Hedge fund industry in India is relatively young, and it got a green
flag in 2012 when the Securities and Exchange Board of India (SEBI)
allowed alternative investments funds (AIF). They have the following
features:
High Net-Worth Investors
Only qualified or accredited
investors can invest in hedge funds. They are mainly high net worth
individuals (HNIs), banks, insurance companies, endowments and pension funds. The minimum ticket size for investors investing in these funds is Rs 1 crore.
Diverse Portfolio
Hedge funds have a comprehensive portfolio
of investments ranging from currencies, derivatives, stocks, real
estates, equities, and bonds. Yes, they necessarily cover all the asset
classes only limited by the mandate.
Higher Fees
They work on the concept of both expense ratio and management fee. Globally, it is ‘Two and Twenty’, meaning there is a 2% fixed fee and 20% of profits. As for hedge
funds in India, the management fee can well below 2% to below 1%. And
the profit sharing varies between 10% to 15% generally.
Higher Risks
Hedge funds investment strategy can expose funds to huge losses. Lock-in period generally for investment is relatively long. Leverage used by these funds can turn investments into a significant loss.
Taxation
The Category III AIF (hedge funds) is still not given pass-through
status on tax. This implies that income from these funds is taxable at
the investment fund level. Hence, the tax obligation will not pass
through to the unit-holders. This is a disadvantage for this industry as
they are not on a level playing ground with other mutual funds.
Regulations
It is not required that hedge funds
be registered with the securities markets regulator and have no
reporting requirements including regular disclosure of Net Asset Values (NAV).
How do Hedge Funds work?
Returns from hedge funds stand testimony to the fund manager’s skill,
rather than the market conditions. Asset managers here do their best to
reduce/remove market exposure and generate good returns despite the
market movement. They function in small market sectors to reduce risks
by more diversification. Some of the strategies that hedge fund managers
use are:
Sell short
Here, the manager, hoping for the prices to drop, can sell shares to buy-back in future at a lesser price.
Use arbitrage
Sometimes the securities may have contradictory or inefficient pricing. Managers use this to their advantage.
Invest in an upcoming event
For instance, some major market events like acquisitions, mergers, and spin-offs among others can influence manager’s investment decisions.
Invest in securities with high discounts
Some companies facing financial stress or even insolvency will sell their securities at an unbelievably low price. The manager may decide to buy after weighing the possibilities.
Comparing Hedge Funds & Mutual Funds
Investment Stance
Hedge funds generally have an aggressive stance on their investments and seek higher returns using speculative positions and trading in derivatives and options. They can take short positions (Short Sell) in the markets, while mutual funds cannot. Short selling allows these funds to benefit even in the falling markets, which is not so for mutual funds.
Leverage
Mutual funds are safer as they don’t have much leverage, whereas hedge funds have a huge amount of leverage and thus attract higher risk.
Investors
Hedge funds are available only to
High net worth investors. Whereas Mutual funds are accessible to the
large group of people. In fact, you can start a SIP with the amount as
low as Rs. 500. In short, hedge funds are comparatively high-risk funds that aim higher returns compared to mutual funds.
For more information on this, visit TAXAJ
Posted by Aashima
Team TaxaJ
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