6/3/2019 Hedge Funds in India - Meaning, Features, Benefits & Comparison

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/ Hedge Funds & How They Differ From Mutual Funds

Hedge Funds & How They Differ From

Mutual Funds
Updated on May 31, 2019 - 12:19:39 PM

Hedge funds are still at an initial phase and is not as widely known as other mutual fund types
(https://cleartax.in/s/mutual-fund-types). Though they too collect money from 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.

1. What are Hedge Funds?

2. Who should invest in Hedge Funds?
3. What are the Features & Benefits of Hedge Funds?

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4. How do Hedge Funds work?
5. Comparing Hedge Funds & Mutual Funds

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1. What are Hedge Funds?

To hedge means to safeguard, and in the context of investing, it means to safeguard 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 like derivatives, equities (https://cleartax.in/s/equity-funds),
bonds, currencies and convertible securities. Hence, they are also called 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 (https://cleartax.in/s/mutual-funds), they tend to
employ substantial leverage. They hold both long and short positions, including positions in listed and unlisted
derivatives.
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6/3/2019 Hedge Funds in India - Meaning, Features, Benefits & Comparison

2. 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 a 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.

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3. 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 Securities and Exchange

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Board of India (SEBI) allowed alternative investments funds (AIF). They have following features:

a. High Net-Worth Investors

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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 (https://cleartax.in/s/pension-plans-india).
The minimum ticket size for investors putting money in these funds is Rs 1 crore.

b. Diverse Portfolio
Hedge funds have a wide portfolio (https://cleartax.in/s/build-portfolio-funds) of investments ranging from
investments in currencies, derivatives, stocks, real estates, equities, and bonds. Yes, they essentially cover all
the asset classes only limited by the mandate.

c. Higher Fees
They work on the concept of both expense ratio (https://cleartax.in/s/expense-ratio-mutual-funds/) 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.

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6/3/2019 Hedge Funds in India - Meaning, Features, Benefits & Comparison

d. 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.

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e. 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. (https://cleartax.in/s/different-mutual-funds-taxed)

f. 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) (https://cleartax.in/s/nav-important-selecting-
mutual-fund/?ref=articles-search).

4. How do Hedge Funds work?

Returns from hedge funds actually stand testimony to the fund manager’s skill, rather than the market conditions.

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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:
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a. Sell short:
Here, the manager, hoping for the prices to drop, can sell shares to buy-back in future at a lesser price.

b. Use arbitrage:
Sometimes the securities may have contradictory or inefficient pricing. Managers use this to their advantage.

c. Invest towards an upcoming event:

For instance, some major market events like acquisitions, mergers, and spin-offs among others can influence
manager’s investment decisions.

d. 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.

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6/3/2019 Hedge Funds in India - Meaning, Features, Benefits & Comparison

5. Comparing Hedge Funds & Mutual Funds

a. 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 (https://cleartax.in/s/mutual-funds/?ref=articles-search).

b. Leverage
Mutual funds are safer as they don’t have much leverage, whereas hedge funds have a huge amount of leverage
and thus higher risk.

c. 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.
However, choose wisely and check if the manager’s strategy works for you. A hedge fund is only one of the
investment avenues, and it takes an in-depth study to assess different options. This is where ClearTax Invest
(https://cleartax.in/save) makes it convenient for you. We have done the research for you and hand-picked the
best performing funds from the top AMCs. Start investing.

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