Hedge Funds – Features & Difference Between Hedge Funds and Mutual Funds

Hedge funds are in an introductory phase in India and are yet to gain popularity among investors as compared to mutual funds. These can be compared to mutual funds since they involve the pooling of investments from various investors. However, hedge funds use many complex strategies to ‘hedge’ against risks and fetch high returns. Here, we will discuss everything that an investor must know about hedge funds, their key features, and also how these work.

What is a Hedge Fund

A Hedge Fund pools funds from investors to invest in domestic and international markets. The main objective of these funds is to generate quality long-term returns. The term “Hedge” means to protect against any potential financial loss or other adverse events. Hedge funds are usually established as private investment limited partnerships that allow only accredited and institutional investors to invest their money.

The Securities and Exchange Board of India (SEBI) has classified hedge funds within Category III as part of Alternative Investment Funds. Hedge funds are defined as funds that employ diverse or complex trading strategies for investment and trading in securities with diverse risk profiles or other complex products that may include listed and unlisted derivatives.

Hedge fund investments help to hedge against market risks. The investment style in these funds aims to generate returns with reduced risks. Hedge funds are known to be far riskier as compared to mutual funds and other saving instruments and are therefore not suited to all investors.

Salient Features of Hedge Funds

Here are some of the noteworthy features of hedge funds:

• Superior Return generation :The main objective of hedge funds is to generate market neutral returns. These focus on portfolio diversification and adoption of trading strategies that help in generating returns during market upswings and downturns.
• Profit Maximisation: The leveraging and borrowing techniques adopted in hedge funds are intended towards profit maximisation.
• Unrestricted investments : Hedge funds do not follow restrictions on investment avenues and they can invest in every kind of financial instrument. Various investment vehicles like land, real estate, equities, debt securities are used for risk mitigation in hedge funds. This is what differentiates hedge funds from conventional mutual funds.
• Charges and Fees: Hedge fund expense ratios include an asset management fee and performance fee. Globally, hedge funds charge 2% of the total assets as expense fees and an additional 20% of the total returns is charged as a performance fee. Therefore, hedge funds are more expensive as compared to other investment options. In India, hedge funds do not have a specific fee. Expense ratio can be anywhere around 2% and performance fee could range between 10% to 15% of the returns.
• High minimum investment: The minimum investment amount in hedge funds in India is Rs. 1 crore. This is a substantial sum for retail investors who prefer to invest in mutual funds using the Systematic Investment Plan (SIP) option.
• Not well regulated :In India, hedge funds are not entirely regulated as compared to mutual funds and other commonly available financial instruments.

Who should invest in Hedge Funds?

Hedge funds are ideal for Institutional investors, accredited investors, high net worth individuals (HNIs), insurance firms, banks, etc. who have a large corpus to allocate towards their investment portfolio.

Since hedge fund managers buy and sell securities as per market fluctuations, these investments are ideal for investors with a high-risk appetite. The portfolio management strategies used in hedge funds are aggressive and therefore not fit for individuals with low-risk tolerance.

Hedge funds also come with a lock-in period of at least one year before investors can redeem their investment. Thus, investors who prefer high liquidity should look for alternatives like mutual funds or equity investments.

Expense and taxation on Hedge Funds

The complex investment strategies of hedge funds make them expensive as compared to regular mutual funds. Globally, hedge funds have the ‘Two-Twenty Rule’, under which the expense fee is set at 2% of the total assets and the performance fee is 20% of the total returns. In India, there is no fixed management fee. The expense ratio could be anything around 2% or lesser. The performance fee generally varies between 10% to 15%.

Since this investment category is classified under Alternative Investment Vehicles, the applicable tax rate is 42.74% on annual earnings above Rs. 5 crores. Returns are taxed at the investment fund level, thus taking the tax liability off investors.

Comparison between Hedge Funds & Mutual Funds

Here are some comparison points that help to distinguish hedge funds from regular mutual funds:

1. Investment Approach

Hedge funds generally adopt an aggressive investment approach and aim for higher returns through speculative positions. These also trade in derivatives and options for enhanced returns. Short positions (Short Sell) are commonly used by hedge funds to benefit in case of falling markets. Mutual funds can not pursue this as the strategies have to be in line with the risk category of the mutual fund while prioritising investor interests.

2. Leverage

Mutual funds are safer since they involve far lower leverage as compared to hedge funds. This limits the risk of mutual funds, whereas hedge funds attract higher risk.

3. Investors

In India, hedge fund investments are available only for High net worth investors. Mutual funds, on the other hand, are accessible to all kinds of investors. Many investors prefer to invest in mutual funds through SIP with an amount as low as Rs. 500. A hedge fund investment requires in-depth knowledge and research for assessing the strategies used. Mutual funds are ideal for new investors who have limited knowledge of the markets as the risk and return profiles of these are known to the investor before starting the investment.

Conclusion

Hedge funds are still new to the Indian investor market due to a lack of capital resources, various regulations, etc. Experts are observing this investment form slowly mushroom through a lot of hurdles. Heavy taxation on hedge fund returns is also discouraging investors from trying out this investment vehicle. 

FAQs

1. What is the minimum amount required to invest in a hedge fund?
   A hedge fund requires a minimum investment of Rs. 1 crore. To set up a hedge fund, the minimum investment amount must be Rs. 20 crore.

2. Who regulates hedge funds in India?
   Securities and Exchange Board of India (SEBI) regulates hedge funds in India. It classifies hedge funds as Alternative Investment Funds.

3. Are hedge funds high risk?
   Hedge funds involve strategies to hedge the risk while maximising returns. Hedge funds adopt more aggressive strategies as compared to mutual funds. The losses in hedge funds can be quite high during market downturns just like expected profits during upswings. Hedge funds also do not offer liquidity since the investment is locked in for the long term.

4. Can I invest in hedge funds?
   In India, hedge fund investments are primarily meant for HNIs, qualified investors, banks, insurance companies and other institutions who have sizable funds with them.

5. What is the difference between a mutual fund and hedge fund?
   Mutual funds are investment products available to the public. Hedge funds are private investment vehicles that are available only for accredited investors. Hedge funds involve higher risk because of the investment strategies that are designed to achieve higher returns. Mutual funds come with varying degrees of risk and investors can invest as per their risk profile.

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