What is a Hedge Fund?
A private pool of funds generated by partnerships of different investors, a hedge fund is an investment plan employing various investment strategies to earn high profits.
Still wondering what a hedge fund is? A non-traditional investment plan that is collectively generated by a group of hedge fund investors looking to earn a higher return. Unregulated and alternative funds, hedge funds can be either global or country-specific in nature.
This means that either a hedge fund can be invested in an overseas investment opportunity or in a country-specific opportunity as determined by the partners of the hedge fund.
Unlike mutual funds investors who are overseen by the SEBI, hedge fund investors are led by a hedge fund manager who handles the investment of the pooled finances and the whereabouts of the same.
(Must read - Mutual Funds - Types and Benefits)
How does it work?
If you are thinking of how hedge funds work, here is a brief introduction. Since hedge funds are privately pooled investment funds, they work as per the regulations set by the investors of a particular hedge fund. Although there is no one to oversee the operations of a hedge fund, it works according to the terms and conditions as prescribed by the various partners.
While mutual funds let people from all income brackets invest in them, hedge funds have a distinct parameter. Generally, high net worth individuals, pension funds, banks, and insurance firms are allowed to invest in hedge funds. (learn more about mutual fund in India)
Since investing in hedge funds is not a cheap deal, the investors are required to have a minimum of net worth in order to be eligible for this type of investment partnership.
By involving a series of features, hedge funds have a 2 and 20 fee structure that implies that the hedge fund manager is eligible to receive 2% of assets and 20% of profits each year.
What’s more, hedge fund managers are also eligible to receive bonuses as per the fund’s performance. Apart from this structure, a hedge fund allows people with a high-end income to invest their money in profitable opportunities like real estate, equities, currencies, and other securities.
The objective of this concept is to ‘hedge’ or protect one’s money by reducing the potential risks on the investments. However, hedge funds are adversely known for their risky investments and high returns on rapidly changing assets.
Known as alternative investment plans, hedge funds can either opt for leverages, derivatives, or even acquire stocks for a short period of time. In order to invest the pooled funds in a certain asset, there are a couple of features that hedge funds consist of. Let us find out some of the most common hedge fund features
(Must read - What are derivatives?)
6 Features of a Hedge Fund
Herein, we will discover the various features of a hedge fund. These are as follows -
Features of Hedge Fund
Hedge funds are known for their little liquidity feature. That’s right. If you are planning to invest in a hedge fund, keep a note that hedge funds do not allow the withdrawal of liquid money at any point in time.
There is a certain limit as to how much liquid money an investment partner can withdraw.
Where there is profit, there is a risk! Hedge funds are an extremely risky alternative investment.
Even though they promise high returns and hefty profits, hedge funds are subjected to market risks. What’s more, hedge funds are aggressive in nature, making them prone to hefty losses.
(Similar blog: Types of financial risks)
While hedge funds are private pooled funds, they are still taxable by the government.
For instance, “The taxation is heavy on Hedge funds in India. They come under the Category III of AIF, the tax rate is 42.74% on annual earnings over INR 5 crores.” Taxable Hedge Funds in India
Another striking feature of a hedge fund is that it has a diverse fund portfolio. This means that a hedge fund can be either invested in non-traditional assets or traditional assets, depending on the best possible returns.
Considering that hedge funds are open to unconventional investments too, hedge fund managers often opt for derivatives, currencies, leverages, and equity funds.
Since a hedge fund manager operates the investment assets of a hedge fund, s/he demands a fee ratio that is defined by the ‘two and twenty’ structure.
This structure implies that of all the assets and profits earned by the hedge fund, the manager is subjected to receive 2% of assets and 20% of profits earned in a year. Thus, before investing beware of this feature.
Minimum Investment Cap
Unlike mutual funds, hedge funds have a minimum investment cap that leads to a demarcation of eligible investment partners. In a hedge fund, high-net-worth individuals (HNIs), banks, and insurance firms are eligible for becoming investment partners.
Moreover, the minimum investment cap for a hedge fund in India is INR 1crore. This becomes an important feature of a hedge fund.
(Also read - 10 Benefits of the Stock market)
Strategies of Hedge Funds
As we have just read about the various features of hedge funds, we will now look at the most common strategies of hedge funds that exist in practice.
Even though the most successful hedge fund managers have never revealed the secret to their success, some of the strategies have surfaced over time. Let us get started.
Long-short/ Equity Hedge Fund Strategy
One of the oldest hedge fund strategies, this strategy works on both the upside and the downside of long and short stocks in the case of equity investment. In stock markets, long stocks are the ones whose prices are expected to rise in the future, while short stocks are those whose prices are about to go down in the days ahead.
Under this hedge fund strategy, one explores the potential price highs and lows in the case of two competing companies wherein one outperforms the other.
The hedge fund manager shorts the stocks of the company that are likely to reduce in price and buys the exact number of stocks of the company whose share price is expected to rise.
This way, shorting and buying long stocks makes money that, in either of the scenarios, turns out to be profitable for the hedge fund.
The market exposure of this strategy is net long and if, in case, the assumed condition turns upside down, the hedge fund may have to bear huge losses as well.
Here is an example for you to understand the same.
“For example, if General Motors (GM) looks cheap relative to Ford, a pairs trader might buy $100,000 worth of GM and short an equal value of Ford shares. The net market exposure is zero, but if GM does outperform Ford, the investor will make money no matter what happens to the overall market.”-Long-Short/Equity Hedge Fund Strategy
Market Neutral Hedge Fund Strategy
Unlike the long-short/equity strategy that has a net long market exposure (a condition wherein a trader possesses more long stocks than short stocks), the market-neutral fund strategy aims for a net-zero market exposure that involves short and long stocks with an equal market capital.
This particular strategy aims for positive returns even when the stock market is doing sluggish or fairly well. However, it must be noted that the return under this strategy is comparatively low.
Even though this strategy is less risky than the long-short/equity strategy, it does not mean that the hedge fund will make more profit.
The sole principle behind this strategy is that market-neutral hedge funds witness a boost in their profits because they are independent of market fluctuations. Instead, they rely on the price movements of the stocks involved.
(Suggested read: Capital in Economics)
Event-driven Hedge Fund Strategy
As the name itself suggests, the event-driven hedge fund strategy aims to target corporate activity and financial events.
Meant to be more suitable in times where there is economic strength, this strategy eyes corporate events like bankruptcy, mergers, reformations, and takeovers.
This event-driven financing strategy aims to exploit the vulnerability of a company’s stock price to fluctuate during a corporate event. The mispricing of stocks during a corporate event of a company leads an investor of a hedge fund to take advantage of such a situation.
During such an event, a hedge fund may decide to invest based on the analysis conducted on the company and its potential event crossovers.
“A decision is then made about how to invest, based on the current stock price versus the likely price of the stock after the action takes place. If the analysis is correct, the strategy will likely make money. If the analysis is incorrect, the strategy may cost money.”-Event-driven Strategy Analysis
Benefits of a Hedge Fund
While hedge funds are known for their drawbacks like risky investment alternatives and illiquid capital, there are multiple benefits of hedge funds that we are going to discover in this segment.
Hedge funds elevate your financial portfolio as they invest your capital in risky yet profitable assets.
A high-profile portfolio is one of the biggest advantages of hedge funds that not only reflect on an individual’s investment opportunities but also portrays the investment alternatives opted for - derivatives/equities/real estate, etc.
(Recommended blog: What are RBI bonds?)
Expertise in Investment
Unlike mutual funds that invest in conservative and traditional investment approaches, hedge funds intend to explore the world of investments by investing hefty capital in non-traditional assets.
Hedge fund managers provide expertise in investment and perhaps invest your capital in the best possible asset.
Independent of Market Fluctuations
Hedge funds are independent of market fluctuations. As hedge funds depend less on fixed income markets and more on money-making assets, hedge funds remain independent of market fluctuations and thus, hedge fund capitals are less vulnerable to volatility.
(Read also: 4 types of Bonds)
To sum up, a hedge fund is a privately pooled investment that belongs to a group of investment partners. Operated by a hedge fund manager, a hedge fund has no one to oversee it and thus, is an unregulated alternative investment fund.
Some of the features of a hedge fund are its risky nature, illiquid capital withdrawal, minimum investment limit, and the two and twenty structure. All in all, a hedge fund is a risky, highly profitable, and taxable investment fund. Lastly, a hedge fund always looks for both traditional and non-traditional assets for investment in order to gain hefty profits.