This article is written by Khushnum Motafram, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.com. Here she discusses “What are Hedge Funds?”.

Introduction

Hedge Funds is one of the financial instrument that is used in raising capital funds from the market and often called as capital market instrument. These financial instruments play an integral part in the growth of the capital market worldwide. Since the number of known and used financial instruments are quite less in the market, financial instrument innovation is imperative for the continuous growth of the capital market. Innovation in financial terms means improvising an existing financial instrument through introduction, deduction or modification of various factors such as interest rate, change in tax structure and regulatory changes etc. 

Concept of Hedge Funds

Hedge Funds is the young baby of the Indian market. It was given a green signal to function in the year 2012 when the Securities and Exchange Board of India (SEBI) gave a go-ahead to the alternative investment funding in India. As per Clause 2(1)(l) of the Securities Exchange Board of India (Alternative Investment Funds) Regulations, 2012, hedge fund means an Alternative Investment Fund which employs diverse and complex trading strategies and invests and trades in securities having diverse risks or complex products including listed and unlisted derivatives.  

Hedge Funds are generally unregistered private investment partnerships or funds or pools that may invest and trade in many different markets, instruments, strategies including securities, non-securities and derivatives. One of the major highlights of Hedge Funds is that it is not subject to the same regulatory requirement as are applicable to mutual funds, including a specific requirement of providing certain periodic and standardized pricing and valuation information to the investors.

Hedge Fund portfolio consists of various types of securities i.e. equity, bonds, debentures and convertible securities etc. Hedge Funds are a collection of funds from accredited investors like banks, financial institutions, pension funds and high net worth individuals etc. Minimum investment amount by any investor should at least be INR 1 crore. These funds are then invested in varied securities across the market in order to hedge risk to the investees’ money against the market’s ups and downs. Furthermore, since these funds are managed by private investment experts, they are costlier to invest in. These private experts charge fees under two heads i.e. performance fees ranging from 15% to 20% of the return value and fixed fees ranging from 1% to 2% of the total investment making it feasible only for someone who has surplus funds and is a risk-seeker.  

Some examples of hedge funds include names like Munoth Hedge Fund, Forefront Alternative Investment Trust, Quant First Alternative Investment Trust and IIFL Opportunities Fund. There are others such as Singlar India Opportunities Trust, Motilal Oswal’s offshore hedge fund and India Zen Fund.

Key Characteristics of Hedge Funds

1. Hedge Funds are generally organized as unregistered private investment partnerships or offshore investment corporations;
2. The investment mechanism of Hedge Funds involves a wide variety of trading strategies including position-taking in a range of market;
3. A varied amount of risk management techniques, trading techniques and instruments including short selling and leverage are employed;
4. Pays performance fees to their managers;
5. Hedge Funds have relatively high minimum investment limit;
6. Investor base of the Hedge Funds compromises of wealthy individuals and institutions.

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Types of Hedge Funds

Basically, there are two types of Hedge Funds: 

1. Domestic Hedge Fund

These Hedge Funds are generally created in the form of limited partnerships. They are created for investors who are subject to the income tax regime of the United States of America. These funds can also be created in the form of Limited Liability Corporation (LLC) or Business Trust. Since LLPs, LLCs and business trusts are not separately taxed in the US, income is taxed only at the level of the individual investors.

2. Offshore Hedge Fund

These Hedge Funds are generally created in the form of corporations in various countries including Cayman Island, the Bahamas, and Panama etc. These offshore Hedge Funds are funded by U.S based tax exempted entities as well as from non-U.S. residents. Offshore Hedge Funds are generally funded by U.S. tax exempted entities because such entities may be subject to taxation if they invest in domestic limited partnership hedge funds. 

Strategies of Hedge Funds

Hedge Funds strategies are basically divided into four categories. All these strategies have their own risk and return profiles. It is not compulsory for these funds to employ a single strategy for their investment in different portfolios. They may use different strategies at the same time to achieve the best return for their clients. These strategies include elements like hedge funds entering the market, the instrument used for hedging, the market sector, diversification of funds within that market sector in different instruments etc.

1. Directional Trading 

Based upon speculation of market direction in multiple asset classes. Both model-based systems and subjective judgment are used to make trading decisions. 

2. Relative Value

Focus on spread relationships between pricing components of financial assets. Market risk is kept to minimum and many managers use leverage to enhance returns.

3. Specialist Credit

Based around lending to credit-sensitive issuers. Funds in this strategy conduct a high level of due diligence in order to identify relatively inexpensive securities.

4. Stock Selection

Combine long and short positions, primarily in equities, in order to exploit under and overvalued securities. Market exposure can vary substantially. 

Apart from the above-mentioned strategies, managers of Hedge Funds involve in some of the following techniques in order to achieve benefit from the market volatility. It is that is why said, that returns from hedge funds are rather skills of the individual manager and not the market conditions. 

1. Short Selling

Here the managers speculate and sell the securities bestowed with a belief that they will repurchase the securities on a future date at a price lesser than what they are selling it today.

2. Investment in an upcoming event

Managers take advantage of a various major market event such as mergers, acquisitions, spin off, amalgamation and invest in securities accordingly in order to achieve maximum profit. 

3. Investment in securities offered at high discounts

These risk taking managers also invest in securities of companies and entities which are on the verge of insolvency or are financially stressed as these companies or entities are willing to sell their shares at a highly discounted price to attain liquidity. 

4. Use arbitrage

Managers also take advantage of various contradictory or inefficient pricing of securities in the market. Hedge funds are then benefited from these securities at a later stage upon attainment of the fair market value.

Hedge Funds and Mutual Funds

Registration as Alternative Investment Funds under SEBI (Alternative Investment Funds) Regulations, 2012 (“Regulation”)

• As per Clause 3 of the Regulation, every person or entity who wishes to act as an Alternative Investment Fund shall obtain registration from the SEBI by submitting Form A along with prescribed fees. 
• In the event of failure to obtain such registration within the prescribed period, such funds shall cease to carry on its activities as an Alternative Investment Fund (“AIF”).
• Hedge Funds shall obtain registration under the said Regulation as Category III Alternative Investment Fund. 
• As per Clause 6 of the Regulation, SEBI may grant certificate of registration to the entity in Form B upon satisfaction that the applicant has fulfilled all the necessary requirements as are specified in the Regulations. 
• As per Clause 13 of the Regulation, Category III Alternative Investment Fund may be open-ended or close-ended.

Further, Hedge Funds registered with SEBI as Category III Alternative Investment Fund are also subject to various conditions concerning investment as given in Clause 10, 15 and 18 of the Regulation. Also, these Category III Alternative Investment Fund are subject to certain general obligation and transparency requirement as are given under Clause 20 and 22 of the Regulations respectively.

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