What are Hedge Funds?

Created on 23 May 2019

Wraps up in 3 Min

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Updated on 11 Sep 2022

Learn how Hedge Funds operate, make money and structure.

A hedge fund is popularly called as alternative investment fund (AIF) in India. Going by the meaning of the word ‘hedge’ which means ‘to avoid,’ so hedge funds talk about avoiding the risk of investment. Though hedge funds are mistakenly taken as similar to mutual funds there is a great deal of difference in the two.

The hedge funds are usually not registered with SEBI and do not disclose NAV regularly as in case of mutual funds. (NAV stands for Net Asset Value which shows the value of each share of the mutual fund). A hedge fund is a pool of money collected from pensions, HNIs, banks, and insurers.

A hedge fund portfolio consists of different classes of funds such as equities, currencies, bonds, derivatives and convertible bonds. Hedge funds take big leaps of risks and are handled by portfolio managers. Hedge funds are usually costly as compared to mutual funds. They often can eat up to 15 to 20% of your returns and involves aggressive buying and selling of assets or derivatives. If you are a first-time investor, then mutual funds are a much safer bet then hedge funds. 

How do hedge funds operate?

Say, for example, you have started a limited liability company called ABC Ltd. Now, an operating agreement is signed between you and hedge fund manager stating that the fund manager will keep the first 5% of investment value. And, out of the remaining investments, 80% of profits will be held by you, and the remaining 20% will go to the hedge manager. Say you invested, Rs. 1 crore in the funds. After making some promising investments, the money grew to Rs. 2 crores. So, as per the agreement:

1. 5% of the investment value goes to the hedge manager = 5% of 1 crore = 5,00,000 Rs. (5 lakhs)

Balance sum of investment = 1 crore – 5 lakhs = 95 lakhs

2. 80% of profit goes to you = 80% of 95 lakhs = Rs. 76 lakhs.

3. 20% of profit goes to hedge fund manager = 20% of 95 lakhs = Rs. 19 lakhs

So, you walk out with a massive profit of Rs. 76 lakh which is not bad at all. 

How do hedge funds make money?

Here, are some ways in which hedge funds make money, such as:

Fast selling: Hedge funds are sold and bought frequently with the belief that the same funds will be available at lower prices in the future.

Distress sale: The hedge fund manager regularly observes and speculates the fund market. There are some companies that are not doing well presently and are either close to bankruptcy or had their image tarnished due to some unforeseen circumstances. The hedge fund manager places bet on these funds, and, if the company turns around then, of course, he ends up making huge profits. 

Arbitrage: Buying funds at a lower price in one market and selling them at a higher price in some other market is referred to as arbitrage. Arbitraging is done to make money due to the price difference of the same funds/shares in different markets.

What is the structure of a hedge fund?

Hedge fund operates in the following manner:

General Partner: There are two partners in this set-up – general partner and limited partner. The general partner takes care of the functioning part of the fund whereas limited partners finance the funds. 

Fee structure: The fee in hedge funds is much higher than mutual funds as we have discussed earlier. The management fee of 2% is usually charged for managing hedge funds. The hedge fund manager takes a 20% profit which may go up to 50% also in some cases.

Lock-up period: Usually, a lock-up period of one to two years is followed in hedge funds. The redemptions may follow monthly, or even quarterly.

How to invest in hedge funds?

For investing in hedge funds, you must follow the given steps:

1. Choose upon the fund manager by doing his background check to see his past performance.

2. Procure the prospectus of hedge funds and learn about the expense ratio and the fee involved.

3. Check the lock-in period of hedge funds along with the terms and conditions for redemption and subscription.

Unlike mutual funds, hedge funds often look for absolute returns. If you have been investing in mutual funds and securities for quite a while, then, hedge funds can be a good option. The hedge fund manager is often very dedicated as he invests in these funds, unlike the mutual fund manager.

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