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What is Hedge Fund & How it is Different from Mutual Funds?

Last Update Date : April 30, 2019
Estimated Read Time: 5 min

Hedge Funds are an instrument of investment which pools money from various investors and are put into various financial assets. It is mysterious in nature; open only to the financially enlightened HNIs, Institutions such as banks and insurance companies as it involves huge amount of risk, delivering huge turns when compared to the stock market. The fund manager uses leverage and derivatives to deliver huge returns; keeping the risk minimised by using the principle of hedging (diversifying it across various instruments of investment).

Difference Between Hedge Fund and Mutual Fund

Hedge FundsMutual Funds
Cannot be advertised publiclyIt can be advertised
Only sophisticated investors are welcome to invest in it (like HNIs, Pension Funds, Endowment plans, Insurance companies)Anybody can invest in it
Minimum ticket size for investing in Hedge Fund is Rs 1 CroreMinimum ticket size for investing in Mutual Fund is Rs 500
It is not regulated as it is mostly in the form of partnership between the investors and the fund managerIt is highly regulated as it is registered with SEBI
Periodic disclosure of its position is not mandatoryPeriodic disclosure of NAV is mandatory
Returns are generally higher than that of the stock marketReturns are comparatively lower when compared to Hedge Funds
Chances of fraud is there as it is not transparentChances of fraud is negligible as it is highly regulated by SEBI
Fee paid to the fund manager is linked to the performance of the fund except the fixed chargesFee paid to the fund manager is irrespective of the performance of the fund
Management fee is very highManagement fee is comparatively lower
It cannot be sold easily (generally their lock in period is quite long)One can redeem it as per their wish (usually their lock in period is of smaller duration)
Fund Manager is free to exercise highly sophisticated strategies (e.g. short selling) involving huge amount of riskFund Manager is restricted when it comes to application  of investment strategies

Structure of Hedge Fund and its Various Types

Generally, Hedge Fund is formed or structured in 3 ways, which is; domestic, offshore and a mixture of both. Different combinations can be used to design it.

Hedge fund comprises of:

  1. Investors
  2. Fund Manager
  3. Administrators and Auditors
  4. Legal Advisors, Transfer Agents and Registrar
  5. Prime Broker
  6. Executing Broker

Various Types of Hedge Funds

Long-Short Funds

A strategy of both short and long position is practised by the fund manager, i.e. buying an asset when it is cheap and selling it when it becomes expensive.

Event-driven Funds

These funds earn by taking advantage of the events which drive the market such as political developments, influencing the prices of the securities.

Macro Funds

These are riskier funds investing in various kinds of securities; whose price changes as per the economic developments.

Emerging Market Funds

They intend to earn by investing in the securities of the developing economies.

Short-only Funds

These funds earn by short selling, i.e. selling securities today at a higher price and then buying it back in the future when its price falls down thereby making profits.

Long-only Funds

These funds earn by forecasting the prices of the stocks to go up in the future by taking long positions.

Merger Arbitrage Fund

It makes its earnings by selling and buying the stocks of companies which are experiencing merger and acquisition which in turn makes the stocks of acquiring company decline and that of the acquired company increase. The stocks of the about to be acquired company trades at a lower price when compared to the offer price as there is doubt regarding happening of the merger in the coming days.

Fixed Income Arbitrage Funds

It earns on the basis of price differences offered to the securities in various markets, but it concentrates basically on the market offering it a fixed income.

Distressed Securities Fund

Securities of a company such as bonds, trade claims, common stock which is in distress are of good thought to buy at huge discounts. In case the company goes bankrupt, these securities in this fund will carry no meaning.

Management Fee of Hedge Fund

Normally they charge 2% of the funds as the management fee (which is fixed) and a 20% of the profits, so it is also cited as “2 and 20”.

Benefits of Investing in Hedge Funds

Higher Rate – They have usually outperformed the markets by offering a higher rate of returns when compared to other vehicles of investment.

Diversified Asset Allocation and Application of Aggressive Strategies – As the fund manager is allowed to invest in the most aggressive forms of instruments of investment by safeguarding itself (hedging) against the risks thereby applying sophisticated strategies fetches higher returns when compared to the market.

Top Performing Hedge Funds

  1. Citadel
  2. Bridgewater Associates
  3. Two Sigma
  4. Renaissance Technologies
  5. Point 72 Asset Management
  6. MAN Group
  7. AQR Capital Management
  8. D. E. Shaw & Co.

How to Invest in Hedge Funds?

Sophisticated investors like HNIs, Insurance firms can invest in a Hedge Fund by researching the track record of the fund manager, reading the memorandum offered by the fund (and other related documents), understanding the strategy of investment, checking whether the fund is using leverage or other techniques, understanding the limitations for its redemption, understanding the value of fund’s assets, inquire about the fees and filling up the form.

Forms and Charges

An accredited investor needs to fill up a “Hedge Funds Application Form” by filling up their information regarding their details, Source of income, Investor classification, Tax details, FATCA Declaration, Tax status, Source of funds for this investment, Communication preference, Investor banking details, Investor declaration etc. They charge 2% of the funds as the management fee (which is fixed) and 20% of the profits.

Risks and Rewards

Risk comes up with the non-transparent nature of the Hedge Funds as there is no periodic disclosure of its positions and its long lock-in periods. Hedge Funds are riskier as they deliver higher returns when compared to any other instruments of investment that is why it is open only for the accredited investors. Rewards of investing in a hedge fund are its high returns.

People Also Ask

Q. Have Hedge Funds resulted in frauds?

A. Yes, some of the examples are SAC Capital, The Galleon Group and the Madoff Investment Scandal

Q. Which are the hedge funds available for investment in India?

A. Singlar India Opportunities Trust, Motilal Oswal’s offshore hedge fund, India Zen Fund, IIFL Opportunities Fund etc.,

Q. Is it regulated in India?

A. They are allowed to be functioning in India from 2012, but it is not regulated

Q. Minimum ticket size for investment

A. 1 Crore

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Chetan Chandak (B.Com, LLB)
Chetan is the Head of Tax Research at H&R Block (India) with an experience of more than a decade in tax advising. He is also a regular contributor for some of the leading news publications in India such as Economic Times, Financial Express and Money Control. Professionally, Chetan is fascinated by international taxation and expat-related tax research.

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