HEDGE FUNDS

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.