Unlocking the secrets of Hedge Funds in the stock market
Hedge funds are private, nonregistered pooled investment vehicles that group capital for trading and investing across a wide array of markets, strategies, and financial instruments. Unlike mutual funds, hedge funds do not have to adhere to strict regulatory standards by showing regularly reported standardized pricing and valuation data. They use a mix of tactics, including hedging and arbitrage, looking to give their investors high returns on investments. As such, with the nature of hedge funds being complex and highly risky, their main investors are typically high-net-worth individuals and institutional investors. Hedge Fund Management and Valuation
Hedge funds deal with capital from certified investors such as insurance companies, banks, high-net-worth families, endowments, and pension funds. Most of the funds are operated by private investment partnerships or foreign investment corporations and stay mostly outside the regulatory regime of institutions like the Securities and Exchange Board of India (SEBI). They are also not required to disclose their NAV periodically like mutual funds.
The hedge fund portfolios contain financial derivatives-based assets, along with equities, bonds, currencies, and convertible securities. Thus, they are considered one of the alternative investments. Hedge funds are actively managed investment vehicles with the basic approach of ‘hedging’ against market risks. Unlike regular stocks or mutual funds, hedge funds generally leverage and take long and short positions, thereby investing in listed and unlisted financial derivatives.
Key Characteristics of Hedge Funds
Structure: Hedge funds are mostly structured as private investment partnerships or offshore investment vehicles.
Strategies: They follow, in a systematic manner, various trading strategies involving taking positions in different markets.
Performance Fees: There are performance-related fees for managers.
Target Audience: They target wealthy individuals and institutional investors with high minimum investments.
Who Should Consider Investing in Hedge Funds?
Hedge funds are a lot like mutual funds, except they are privately managed, making them a lot more expensive because of the rapid buying and selling of assets to keep up with the turns of the market. It means that as an investor, you will not only need substantial capital but quite a risk appetite. With greater structural complexity, the risks can be proportionately high. Hence, hedge funds generally have much higher expense ratios than traditional mutual funds. Those are funds that first-time investors or investors with limited capital may want to avoid unless they have a large financial cushion and a risk tolerance to match.
Types of Hedge Funds
- Domestic Hedge Funds: These funds are only available to investors who are taxed in the country where the fund is based.
- Offshore Hedge Funds: The investment vehicle is domiciled in another country, usually a low-tax one.
- Funds of Funds: These mutual funds invest in more than one hedge fund to give the investor diversified manager styles and risk exposures.
It can be further categorized based on the investment strategies the hedge funds follow. For example,
Event-Driven Funds: The funds invest in assets to benefit from price movements as a result of events in business, thus these funds form part of the Merger Arbitrage and Distressed asset funds.
Global Macro Funds: These are long and short in major financial markets, trend- and event-driven in the economy.
Market-Neutral Funds: The strategies in this group lower the risk of being exposed to the market; thus, it involves long/short equity, convertible arbitrage, and fixed-income arbitrage.
Hedge Fund Investment Philosophy
Hedge funds in the stock market are regulated investment vehicles, which are normally reserved for the privileged group of high-net-worth individuals and institutions. Each hedge fund will have its unique philosophy governing its selection of securities and implementing strategies. Unlike traditional long-only investment funds, hedge funds take up much more activities, such as positions in long and short stocks, bonds, commodities, and even their derivatives.
Risk and Return
One of the reasons for relaxed regulatory requirements for hedge funds is their high-risk nature. Their nature is such that they substantially invest in underlying assets prone to risk. Hedge funds take a greater degree of risk since, without have any statutory obligation to register with SEBI or to report their NAV. However, as the theory goes, higher risks have the potential for higher rewards, and hedge funds will normally grant returns at the higher end of the spectrum.
Advantages of Hedge Fund Investments
It has many advantages associated with hedge fund investment, including aligning fund managers’ interests with the investors, flexibility, and an aggressive investment approach. The hedge funds are designed to ensure that the fund manager receives rewards only for performance above certain benchmarks called a high watermark.
More importantly, hedge funds enrich financial markets by increasing efficiency and liquidity. Most hedge fund advisers are involved in speculative trading after extensive research, which would correct the mispricing in the security markets to bring better market price efficiency. Hedge funds also support companies in managing risk through actively trading in the secondary market, thereby passing on financial risk to a portion of the investors and consequently probably reducing financing costs for other sectors.
In the past two decades, hedge funds have gained popularity in India. Their management fees are higher compared to traditional investment funds; however, due to the sophisticated strategies and the potentially high returns associated, they usually attract much attention from high-net-worth individuals and institutional investors.
