Know all about Hedge Funds in India: Strategies and Risks

Hedge funds are a pooled investment of a partnership firm, institution or accredited investors. Hedge funds in India do not work under the guidelines of Securities and Exchange Board of India (SEBI). Hedge funds are comparatively riskier than other kinds of funds as these only target affluent and rich clients or firms to gain high potential returns.

What is a Hedge Fund?

Hedge funds are the pooled investment by unregistered private partnerships to invest and trade in different markets including various securities, non-securities, derivatives. Hedge funds in India are not necessarily registered with the Securities and Exchange Board of India. In India, hedge funds strategies are dependent on the kind of securities the fund is invested in.

How does Hedge Funds in India work?

Professional managers are required to manage hedge funds as these funds use different trading techniques because the funds are invested in equities, debt, futures, and options. Trading in these types of securities requires managers to adopt diversified strategies. Hedge funds in India work on a number of investment strategies such as long/short equity, arbitrage, global macro, distressed securities, etc. are employed to mitigate market inefficiencies and generate better returns.

A glimpse of it: In hedge funds, managers hedge the securities i.e. they can execute short selling in the accounts of clients that would allow them to make significant profits when the prices of stocks tend to fall. Let us look at some of the hedge funds strategies that are beneficial to adopt.

Hedge Funds Strategies

Hedge funding is a complex process and fund managers should adopt well developed hedge funds strategies to invest the funds. Hedge funds are riskier than other ways of investment that should be carefully executed with the help of successfully developed strategies. Here are some of the strategies that are widely adopted by hedge fund managers:

Long/ Short Equity Funds

According to this strategy, investors take long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. This particular strategy is adopted to gain profits from rising as well as falling markets.

Arbitrage

Arbitrage is a practice where traders take advantage of market inefficiencies by generating income from different markets. For example, the same commodity, currencies or securities are priced distinctively in separate markets. It is one loophole where traders reap a margin from varying prices of two distinct markets.

Leverage and Short Selling

Leverage is one of the hedge funds strategies which offers an option to multiply the returns. Leveraging technique is to borrow funds that increase the investment positions. In the other case, short selling allows people to borrow securities to sell them and repurchase them at lower prices.

Risk Management

Risk Management is one of hedge funds strategies where investors diversify their funds across various asset classes and sectors. To manage the risk they diversify the hedge funds into securities like equity, debt, bonds, and others as well as use financial instruments like futures and options to hedge against potential losses.

Global Macro

Investors take their positions relying on the macroeconomic trends including foreign currencies, commodities, interest rates and equities.

What is Hedging?

Hedging is an advanced risk management activity which allows investors to buy or sell their positions to help reduce the risk of existing positions in the portfolio. Hedging is the primary activity in hedge funds to manage the risks if the downfall starts in an investor’s portfolio.

Types of Hedge Funds in India

In what kind of hedge funds you invest the money in India? Hedge funds are very risky and hence managers are required to adopt several strategies by using various types of hedge funds. Let us know the types of hedge funds where managers invest their capital to keep it secure.

Equity Hedge Funds

In equity hedge funds, profits can be generated from buying or selling of the stocks from falling and rising asset prices. Risks are minimized against market downturns by short selling of assets.

Relative Value hedge Funds

Relative value hedge funds seek to exploit price differences between related securities to generate higher returns.

Market Neutral Funds

Market neutral funds is a type of hedge fund where investors seek profits from upward or downward market movement with the use of derivatives and paired long and short term positions.

Macro Hedge Funds

Market fluctuations are recognized and the profits are made by leveraging macroeconomic factors such as inflation and other financial conditions.

Active Hedge Funds / Event Driven Hedge Funds

In active hedge funds, profits are obtained from the companies involved in mergers or acquisition activity and if the company is undergoing several events like restructuring, spinoffs or asset sales.

Hedge Funds Vs Mutual Funds

In mutual funds, only stocks and bonds are used as investment instruments for long term investment strategies. On the other hand, hedge funds investments are widely diversified into several instruments being an aggressive option while employing leverage and derivatives. But what is the basic difference between hedge funds and mutual funds?

The primary difference between hedge funds in India and mutual funds in India is that mutual funds are facilitated by the guidelines provided by Securities and Exchange Board of India while hedge funds are not restricted by SEBI guidelines.

In hedge funds, the management fees and performance fees are comparatively higher than that of the fees in mutual funds.

Risks of Investing in Hedge Funds in India

Before investing in hedge funds in India, investors should conduct a thorough research to meet the investment goals and hence consider the risks. Let us know the risks associated with hedge funds investments in depth.

Liquidity Risk

Investing into hedge funds is subject to liquidity risks as converting the assets into cash is not easy. Hedge funds cannot be sold quickly to meet the liquidity demands, redemption requests or other obligations.

Leverage Risk

The risks associated are gradually increased when the funds are invested by borrowing to increase investment exposure. Leveraging can lead to potential losses and increasing the financial distress of investors.

Operational Risk

Hedge funds are always subject to the risk of loss resulting from inadequate or failed internal processes of the business, people, systems or external events. Investors might have to bear risks due to error in trade execution, fraud or mismanagement.

Strategy Risk

It is not necessary that the strategy adopted by hedge fund investors would perform as expected, it might become obsolete. Due to unexpected market fluctuations, the strategy may go in the wrong direction and might result in financial losses.

Regulatory Risk

Any changes in the rules and regulations by the government about the working of hedge funds and its activities might lead to an increase in operational costs which can restrict certain investment strategies.

The Bottom Line

Hedge funds in India are the pooled investments made by institutions or partnership firms as these are highly risky. A lot of money is required to invest in hedge funds which makes it inappropriate for individual investors. Hedge funds are useful for managing risks by portfolio diversification and using hedging activity. Apart from the benefits, hedge funds contain risks of liquidity, leverage, operational, strategy and regulatory risks.

FAQs