This article is written by Darsha Shetty, a law graduate from Government Law College, Mumbai and a qualified Company Secretary, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.com. She is currently working with Avenue Supermarts Limited ( DMart ) as a CS Management Trainee.
Meaning of Hedge Fund
Hedge fund is an alternative investment vehicle that utilizes complex investment strategies to invest (trade) in a variety of products, to earn a return for its investors. It is structured in the form of a private investment partnership between professional fund managers and investors. The investors pool in their funds for the purpose of investment. The funds pooled in are then managed by the professional fund manager, in consideration of asset management fees and performance fees.
Birth and evolution of Hedge Fund
The post – Great War scenario opened up numerous avenues for wealth creation in the markets, thereby creating an unprecedented demand for collective investment vehicles. Among such investment vehicles was the Graham-Newman Partnership, which has been cited by Warren Buffet as being the earliest example of hedge fund. The coinage of the term “hedge(d) fund” can be attributed to Alfred Jones, who is considered to be the father of the modern hedge fund. In the late 1940s, Alfred Jones was asked by his employers at Fortune magazine to write an article about the current investment trends. It is from here that he took the inspiration to try his hand at being a money manager. He then invested $40,000 from his savings and pooled in another $60,000 from the other investors and launched a fund based on the long/short equities method which he termed as ‘hedged fund’. Thereafter, he changed the structure of the investment vehicle from general to limited partnership and also introduced the performance fee incentive structure for the managing partner. He also employed the use of leverage (i.e. borrowed funds) to amplify investor returns. Jones thus set a template for hedge funds, thereby making him the pioneer of hedge funds.
The Fortune magazine had another pivotal role to play in the development of the hedge fund industry. The world was taking its time to warm up to the idea of a hedge fund as an investment model. It was then that an article published in the Fortune magazine threw light on an obscure investment vehicle that had outshone every mutual fund on the market. This article compelled the money managers to sit up and take notice, thereby paving a way for the development of hedge fund as a real industry.
Characteristics of Hedge Fund
- Accredited Investors: Investments in hedge funds are open only to ‘sophisticated/accredited’ investors i.e. investors with the prescribed net worth or income.
- Regulation: Hedge funds are not required to be registered with the securities market regulator nor do they need to disclose their NAV. The regulatory oversight is negligible in comparison to mutual funds since general public interests are not involved and the accredited investors are deemed to be affluent enough to gauge the risks associated with such funds. Thus, hedge funds are regulation – light. However, the dot com crash of the 2000s and the global economic crisis of 2008 has led to an increase in the compliances for the hedge funds in the United States.
- A wide latitude of investments: Hedge funds can invest in a variety of assets viz. land, stocks, bonds, currencies, derivatives, etc., subject to the restrictions contained in their mandate.
- Fee Structure: Hedge funds charge asset management fees as well performance fees. The fee structure of hedge funds has been subjected to a lot of criticism.
- Illiquid: Investments in hedge funds are illiquid as often there is an initial lock-in period of one year, post which the withdrawals may only happen at certain intervals.
Two and Twenty Fee Structure
“2 and 20” is the compensation scheme used by a vast majority of hedge funds. According to the scheme, the fund manager is entitled to 2% of assets as management fees and 20% of the profits as performance fees.
For Example: For Fund ACB with assets worth Rs. 1000 crore the Fund Manager will pocket management fees worth Rs.20 crore every year. If the fund makes profit of Rs. 400 crore in addition to the management fees he will be entitled to performance fees of Rs. 80 crore. However, if the fund makes no profit or ends up with losses the fund manager will still be entitled to receive the management fees. This aspect of receipt of management fees irrespective of funds’ performance draws a lot of flak. However, it is pertinent to note that many hedge fund managers co-invest in the funds thereby aligning their interests with that of the other investors.
An alternative to this scheme could be the Hurdle Rate structure, whereby the fund manager is entitled to a share in profits, only after the profits exceed a specified hurdle rate.
For Example, The Fund Manager of ACB Fund will be entitled to 30% of profits over 5%. Thus, for a profit of Rs.400 crore the Fund Manager’s fees will stand at 30% of [400-20 (Hurdle Rate)] i.e. Rs.114 crore. Thus, though the fee payable is higher the structure ensures that the manager will be entitled to fees only after earning a certain amount of profits. The Hurdle Rate fee structure thereby aligns the interests of the investors and the fund manager, however, it is rarely used.
Strategies employed by Hedge Fund
The variety of investment strategies employed by hedge funds can be broadly classified into the following four broad categories:
- Long/Short Equity Hedge Fund: In a long/short hedge fund, managers split up investment between investing long in stocks (whose prices are expected to increase) while shorting other stocks (in which there is an expectation of fall in prices).
For Example- The fund manager of the ACB Fund expects a certain Stock A to appreciate and Stock B to decline by the end of 2 months. Hence, he invests 60% of the funds towards long in Stock A and 40% of the funds towards short in Stock B. The Net Exposure to the market thereby stands at 20% (60-40) with no leverage. The gross exposure stands at 100%.
2.Macro Hedge Fund: These are the most volatile hedge fund strategies, whereby the funds invest in a variety of assets in the hope of monetizing on the changes in macro-economic variables viz. interest rate, currency exchange rates, government policy, political climate, etc. These funds are broad-based i.e. they permit investments in a variety of assets and instruments that move based on systematic risks.
3. Relative Value Arbitrage Hedge Fund: These hedge funds typically buy securities that are expected to appreciate while simultaneously selling short a similar security (like a stock or bond from a different company in the same sector or the like) that is expected to depreciate in value.
4. Distressed Hedge Fund: These funds invest in stocks or bonds of distressed companies, in the hope that the companies will soon turn themselves around, thereby leading to an increase in the value of investments. The strategy is risky since there is no guarantee that the distressed companies will be able to revive themselves and ensure appreciation in the value of stocks and bonds.
It is to be noted there are numerous strategies a fund may employ to minimize risks whilst maximizing returns, however, all of those strategies fall within the spectrum of the abovementioned classifications.
Mutual Fund vis-à-vis Hedge Fund
The structure (both pools in resources from investors) and objectives of hedge funds and mutual funds appear to be similar; however, there are key differences between the same which can be understood with the help of the following points:
- Return: The objective of mutual fund is to offer return higher than the risk-free rate of return. Thus, what mutual funds chase returns in relative terms i.e. they aim to outperform the market. Hedge funds, on the other hand, seek absolute returns i.e. a positive return on investment irrespective of the direction of market movement.
- Investors: Retail investors with limited disposable income invest in mutual funds. However, only accredited investors i.e. investors with a particular net worth or annual income are permitted to invest in hedge funds.
- Regulation: Due to the association of general investor interests (because of large amount of retail investors involved) with mutual funds, it is strictly regulated. Mutual funds have to comply with registration as well as reporting requirements as specified by the Market Regulator. The investors of hedge funds are considered to be affluent enough to understand the risks associated with such an investment; hence these funds are subject to limited regulation.
- Fees Structure: The investment advisor of mutual funds is paid fees as a percentage of assets managed. Hedge fund managers, on the other hand, are often entitled to management fees as well as performance fees (as a percentage of profits earned) i.e. they have a share in profits too.
- Liquidity: An investor in Mutual Fund can redeem his investment at any time subject to payment of Exit Load. Hedge funds in comparison are less liquid as often there is an initial lock-in period of one year, post which the withdrawals may only happen at certain intervals.
- Management Style: Hedge funds are more aggressively managed i.e. they invest in a wide variety of assets and employ complex investment strategies in comparison to mutual funds.
The popularity of hedge funds have waxed and waned over the decades. However, they do offer an alternative to the traditional investment methodologies and also bring in opportunities for market neutral return; which in turn ensures that they are here to stay.
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