Hedge Funds – An Insight

- Sumit Kr. Dhanuka & Neha Gupta

Hedge Funds - An Introduction

Since the early 1990s, hedge funds have become an increasingly popular asset class. Hedge funds, including
fund of funds, are unregistered private investment partnerships, funds or pools that aggressively manage
portfolio of investments using advanced investment strategies such as leverage, long, short and derivative
positions in both domestic and international markets. They aim to generate high returns either in an absolute
sense or over a specified market benchmark.

Hedge funds vary enormously in terms of investment returns, volatility and risk. Many but not all hedge fund
strategies tend to hedge against downturns in the markets being traded. Many hedge funds have the ability to
deliver non- market correlated returns. Pension funds, endowments, insurance companies, private banks and
high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and
enhance returns. Hedge funds are managed by experienced investment professionals. They benefit by heavily
weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains
in the investment business. In addition, hedge fund managers usually have their own money invested in their
fund.

Classification of Hedge Funds

Hedge funds are often described as an asset class but this is misleading. Some hedge funds do share certain
return characteristics but they invest in a broad range of different asset classes ranging from equity to debt,
real assets and even property. Hedge funds embrace a range of different strategies aimed at generating
absolute returns. They include credit or fixed
income hedge funds, convertible arbitrage, merger
or event arbitrage, multi-strategy arbitrage and
distressed securities. Another significant group of
Equity Equity
hedge funds falls into the macro category, which hedge long
focus on macroeconomic conditions, taking funds biased
leveraged bets on the direction of currencies, Sector Convertible
interest rates, commodities and stock markets. funds arbitrage
Hedge funds are classified on the basis of the Fixed-
strategies adopted for investment: Event Types of Hedge income
driven Funds hedge
• Equity Hedge Funds funds
Equity hedge funds are the largest single Emerging
Fixed-
category and most of these are long/short income
markets
arbitrage
equity funds investing in domestic or Fund of Global
international stocks. Sometimes these funds funds macro
can be market neutral. However, it is rare that
they have no exposure to the equity market. In
practice such funds are generally net long but
limit their market exposure by selling some
stocks short. As a result, their returns are not
fully correlated to the equity market. Often such hedge funds outperform in a bear and underperform in a
bull.
• Equity long biased
This is the most familiar style of hedge fund which may carry short positions, but the size of long positions
is usually larger than the size of the short positions. The managers usually seek to generate returns by
selecting a narrow portfolio of equity shares. Individual managers may seek to supplement the returns
from stock selection by overlying a market-timing strategy. The portfolios in this group generally have low
leverage (2 to 1 or less).

• Equity market neutral

It exploits price discrepancies by using a variety of strategies through combinations of long and short
positions. Arbitrage trading includes trading between futures and underlying equity (basis or basket
trading), buying and selling related classes of equity shares (pair trading) or certain options strategies.

• Convertible arbitrage
It commonly involves buying undervalued convertible bonds while selling the underlying stock. Convertible
bonds and convertible preference shares are fixed income instruments that may be exchanged for equity
shares. The debt structure offers some downside protection if the investor expects to get back the full
principal value of the investment as a worst case. The market value of the debt is usually closely tied to the
market value of the equity shares because the company can reliably repay the bonds if the company does
well, and if the company does well the equity shares will also do well.

• Fixed-income hedge funds

Fixed-income strategies include hedging strategies that invest in bonds and other fixed income
instruments. Some of the fixed-income hedge funds are fixed income arbitrage, mortgage funds, various
default-risk funds, and emerging markets debt funds.

• Fixed-income arbitrage
It takes positions in instruments based on expected changes in the yield curve and/ or credit spreads. Fixed-
income arbitrage funds rely primarily on debt instruments. Sometimes the group is called just “fixed-
income fund” to recognize that some of these funds retain substantial risks, albeit typically not the risk of
rising or declining rates. The funds combine long and short positions with derivative instruments to hedge
the level of interest rates, the rates of one maturity sector versus other maturity sectors, credit risks, and
other factors.

• Emerging markets
It invests in developing economies and generally involves only long positions. As the name of the category
suggests, emerging markets hedge funds invest in securities issued by companies or countries that don’t
have well-established securities markets. These investments can be either debt or equity investments.
Hedge funds may acquire a widely diversified portfolio of instruments from many countries or may focus
on a particular country or economic region.

• Event driven
The event driven category includes several strategies often tracked separately. This group includes hedge
funds involved with risk arbitrage (also called merger arbitrage), bankruptcy and reorganization and spin-
offs. The category includes funds that invest purely in one of these strategies and multi-strategy funds that
may pursue several of the strategies.
• Risk arbitrage or Merger arbitrage
It focuses on returns from mergers, spin-offs, takeovers, etc. It generally involves buying the target
company of a takeover after an attempt is announced and selling short the acquiring company. Although
complicated terms may require more complicated positions, the typical position includes a long position
that can be delivered to close the short position if the deal is completed.

• Sector funds
Sector funds include a collection of long-only or long biased hedge funds invested in a narrow sector of the
stock market. Sector funds pursue a wide range of sectors, but the most common sector funds involve
health care companies, biotechnology, the technology sector, real estate, and energy. Because these
sectors tend to be volatile anyway, these hedge funds use little or no leverage. The returns on the
individual funds depend on stock selection, but a major part of the return is determined by the
performance of the sector.

• Fund of funds (‘FOF’)

It invests in many hedge funds consisting of approximately 10 to 30 hedge funds. The point is to achieve
diversification, but the extra layer of management means an extra layer of fees. Often a FOF offers more
liquidity for the investor, but the cost is cash drag. Despite the drawbacks, FOF are good entry-level
investments. FOF returns have been more highly correlated with equity markets than those of individual
hedge funds. This characteristic has important implications for their use as a diversifier in an equity
portfolio (i.e., as correlation increases, diversification decreases).

Hedge Funds vis-à-vis other Pooled Investment Vehicles

Other pooled investment vehicles, such as mutual funds, venture capital funds and other private equity funds,
are sometimes referred to as hedge funds. Although all of these investment vehicles are similar in that they
accept investors’ money and generally invest it on a collective basis, they also have characteristics that
distinguish them from hedge funds.

• Mutual funds
Mutual funds are registered with securities markets regulator and are subject to the provisions of the
relevant regulations such as, offer/issue of units/securities, disclosure and reporting requirement, valuation
for the purpose of computation of NAV, conflict of interest issue and limit leverage. Hedge funds are not
required to be registered and therefore, are not subject to similar regulatory provisions.

• Private equity funds

Private equity funds differ from hedge funds in terms of the manner in which contribution to the
investment pool is made by the investors. Unlike hedge funds, private equity investors typically commit to
invest a certain amount of money with the fund over the life of the fund. Private equity funds are long-term
investments, provide for liquidation at the end of the term specified in the fund’s governing documents and
offer little, if any, opportunities for investors to redeem their investments.

• Venture capital funds

Venture capital funds, however, invest in the start-up or early stages of a company. Unlike hedge fund
advisors, general partners of venture capital funds often play an active role in the companies in which the
funds invest. In contrast to a hedge fund, which holds an investment in a portfolio security for an indefinite
period based on market events and conditions, a venture capital fund typically seeks to liquidate its
investment once the value of the company increases above the value of the investments.
Hedge Funds - Market benefits
Hedge funds can provide benefits to financial markets by contributing to market efficiency and enhancing
liquidity. They often assume risks by serving as ready counter parties to entities that wish to hedge risks. Hedge
funds can also serve as an important risk management tool for investors by providing valuable portfolio
diversification.

Hedge funds play an important role in a financial system where various risks are distributed across a variety of
innovative financial instruments. They often assume risks by serving as ready counter parties to entities that
wish to hedge risks. For example, hedge funds are buyers and sellers of certain derivatives, such as securitized
financial instruments, that provide a mechanism for banks and other creditors to un-bundle the risks involved
in real economic activity.

Hedge Fund Regulation in India

Some jurisdictions are gradually moving towards allowing the marketing of hedge fund and fund of funds
products to retail investors. Those jurisdictions have simultaneously imposed disclosure requirements to
ensure that investors understand the complexity and associated risk of investing in hedge funds. Realizing the
growing importance of hedge funds, several emerging market regulators have opened their markets to offshore
hedge funds by providing authorization as registered foreign investors.

In view of the increasing popularity among the institutions as well as their increasing interest in the Indian
market, it might be time to provide a limited window to this growing segment of asset management industry
within the existing framework of the SEBI (Foreign Institutional Investors) Regulations. The approach adopted
in formulating the policies has been that of transparent and regulated access with abundant caution.

The governments, central banks and the regulating agencies have to make a choice between the
efficaciousness of a regulation and the price involved in complying with it. As for the Hedge funds, an
investment sector wary of watchdogs after years of being unregulated, regulators will need to persuade the
fund managers that free flow of information and open dialogue is essential, and that intervention will only
come where market stability is at stake.

Conclusion
Hedge funds are marketed as an “asset class” that provide generous returns during all stock market
environments and thus serve as excellent diversification for an all-equity portfolio. Moreover, although the
funds tend to exhibit low correlations with general equity indices —and, therefore, are excellent diversifiers —
hedge funds are extremely risky along another dimension.

The assets under management of the hedge funds are growing on a double digit rate and it is estimated that
worldwide the hedge fund industry is about $3 trillion dollars. This has created a lot of disquietude for financial
regulators as hedge funds are able to influence markets in a more radical manner than they would do so when
they first started.

In India the issues are intended to widen the FII inflow and to allow these alternative investment pools to our
securities market in a transparent and orderly manner. In addition, the suggestions additionally accommodate
for able assurance measures to address legitimate concerns associated with these funds.

Most industry bodies are of the view that regulation is welcome and in the interest of all if it does not adversely
affect innovation, competitiveness and the industry’s ability to evolve. It’s all about educating the investors and
ensuring they know what they are getting into.