1) "Hedging"
is the practice to reduce risk, but the objective of majority of hedge funds is
to maximize return on investment. The name is historical, as the first hedge
funds tried to hedge against the downside risk of a bear market by shorting
the market.
2) Hedge funds use dozens of different
strategies, so it isn't accurate to say that they just "hedge risk."
In fact, since hedge fund managers make speculative investments, these funds
may carry more risk than the overall market.
3) However, there are mechanisms in place to protect
those who invest in hedge funds. Often fee limitations such as high-water marks are employed to
prevent portfolio managers from getting paid on the same returns twice. Fee
caps may also be in place to dissuade managers from taking on excess risk.
4) Hedge funds are alternative investment funds (AIFs), using pooled capital sourced
from accredited investors or institutional investors (like banks,
insurance firms, High Net-Worth Individuals (HNIs) & families, endowments
and pension funds) and employ different strategies to earn active return or
alpha for their investors, often with complicated portfolio-construction and
risk management techniques.
5) They are private investment vehicles that allow
wealthy individuals to invest. Hedge funds can pretty much do what they want as
long as they disclose the strategy upfront to investors. The minimum ticket size for investing in these funds in India is Rs 1
crore.
6) A hedge fund can basically invest in
anything—land, real estate, stocks, bonds, derivatives, commodities, currencies,
convertible securities, mutual funds,
startups, art, rare stamps, collectibles, gold, wine.
7) They can leverage
(often use borrowed money to amplify their returns) in both domestic and
international markets in quest of generating high returns (either in an
absolute terms or over a specified market benchmark).
8) It is important to note that hedge funds require
less SEC (Securities & Exchange
Commission) regulations than other funds. One aspect that has set the hedge
fund industry apart is that, they face less regulation than mutual funds and
other investment vehicles.
9) It is administered by a professional investment
management firm, often structured as a limited partnership or limited liability
company.
10) Investments in hedge funds are illiquid as they often require investors to keep their
money locked in the fund for at least a year.
11) Following the financial crisis of Yr.2007–2008,
regulations were passed in the United States and Europe with the intention of
increasing government oversight of hedge funds and eliminating certain
regulatory gaps.
12) Preqin Global Hedge Fund Report, the Hedge funds have now grown to total assets
of approx $3.235 trillion in 2018.
13) A hedge fund typically pays its investment
manager annual management fee (for
example, 2% of the assets of the fund), and a performance fee (for example, 20% of the increase in the fund's net
asset value during the year).
Some of the strategies
that hedge fund managers use are:
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) Invest
in an upcoming event: in view
of some major market events like mergers, acquisitions, spin-offs, among others
can influence manager’s investment decisions.
c) Use
arbitrage: Sometimes
the securities may have contradictory or inefficient pricing; managers use this
to their advantage.
d) Invest
in securities with high discounts: Some companies facing financial stress or even insolvency will sell
their securities at an unbelievably low price.
Investors should use
following guidelines for hedge fund
selection:
a) Five-year annualized returns
b) Standard deviation
c) Rolling standard deviation
d) Months to recovery/maximum Drawdown: A drawdown is a peak-to-trough decline
during a specific period for an investment, trading account, or fund. A
drawdown is usually quoted as the percentage between the peak and the
subsequent trough. If a trading account has $10,000 in it, and the funds drop
to $9,000 before moving back above $10,000, then the trading account witnessed
a 10% drawdown.
Drawdowns are important for measuring the
historical risk of different investments, comparing fund performance, or
monitoring personal trading performance.
e) Downside
deviation: Downside is the negative
movement in the price of a security, sector or market. Downside can also
describe periods when an economy has either stopped growing or is decelerating.
f) Fund
Size/Firm Size: The
guideline for size may be a minimum or maximum depending on the investor's
preference. For example, institutional investors often invest such large
amounts that a fund or firm must have a minimum size to accommodate a large
investment. For other investors, a fund that is too big may face future
challenges using the same strategy to match past successes. Such might be the
case for hedge funds that invest in the small-cap equity space.
g) Track
Record: If an investor wants a
fund to have a minimum track record of 24 or 36 months, this guideline will
eliminate any new funds.
h) Minimum
Investment: This
criterion is very important for smaller investors as many funds have minimums
that can make it difficult to diversify properly. Larger minimums may indicate
a higher proportion of institutional investors, while low minimums may indicate
a larger number of individual investors.
i) Redemption
Terms: These terms have
implications for liquidity and become very important when an overall portfolio
is highly illiquid. Longer lock-up periods are more difficult to incorporate
into a portfolio, and redemption periods longer than a month can present some
challenges during the portfolio-management process. A guideline may be
implemented to eliminate funds that have lockups when a portfolio is already illiquid,
while this guideline may be relaxed when a portfolio has adequate liquidity.
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. 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.
b) 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.
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.
d) In short, hedge funds are comparatively
high-risk funds that aim higher returns compared to mutual funds.
Some examples of hedge funds:
Munoth Hedge Fund, Forefront Alternative
Investment Trust, Quant First Alternative Investment Trust, IIFL Opportunities
Fund, Singlar India Opportunities Trust, Motilal Oswal’s offshore hedge fund
and India Zen Fund.
