Hedge Funds: Explore High-Risk, High-Reward Investment Options

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Investors keen on diversifying their portfolios beyond traditional investment may consider investing in hedge funds. While these are undoubtedly risky investments, they also offer the potential for significantly high returns, depending on how the market and the assets in the funds’ portfolios perform. 

What are Hedge Funds? 

According to the Securities and Exchange Board of India (SEBI), hedge funds, including fund of funds, are unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are not subject to the same regulatory requirements as mutual funds.

In layman’s terms, hedge funds are private investment vehicles that pool together the investment corpus from different investors. The collective capital is then invested in a mix of different securities like equity stocks, bonds, convertible securities, derivatives, currencies and real estate, among others. Furthermore, as SEBI’s explanation indicates, these funds may also invest in non-securities like real estate, gold and other such assets. 

Through these investments, hedge funds aim to beat the average returns from the market and simultaneously protect (or hedge) the asset mix from downside risk. To this end, hedge funds adopt complex and often aggressive investment strategies — coupled with adequate risk management measures. 

Additional Read: What is Delta Hedging?

Understanding How Hedge Funds Work

To further understand the nuances of hedge funds, you need to look beyond their definition and see how they work. Hedge funds are designed to outperform the broad market. To achieve this primary goal, they invest in risky market segments and take aggressive positions in various assets. 

However, as their name indicates, these vehicles also have adequate measures in place to protect or ‘hedge’ their core investments. This is done by investing some of the hedge fund’s capital in securities and assets whose prices are expected to move in a direction opposite to the main holdings in the fund’s portfolio. 

For example, say a hedge fund primarily focuses on airline stocks. These stocks may perform well when travel is booming and fuel prices are stable or falling because fuel is a major expense for airlines. To hedge the portfolio against the risk of rising fuel prices — which could negatively impact airline stocks — the fund may also invest in oil futures or the stocks of oil companies. This way, if the airline stocks fall due to rising fuel costs, the gains from the oil-related investments could offset the losses. 

Key Features of Hedge Funds

Hedge funds are defined by a few distinct characteristics that set them apart from many other investment vehicles typically available in the market. For this reason, these funds are considered as alternative investments. Check out the key features of hedge funds here:

  • Varied Investment Strategies:

Hedge funds primarily aim to deliver positive returns no matter what the prevailing market conditions are. To achieve this, they adopt a wide range of diverse investment strategies like arbitrage, leverage, derivatives trading and a mix of short and long positions in different securities. 

  • Adaptability and Flexibility:

While traditional investment vehicles focus on specific types of assets or asset classes, hedge funds are more flexible in their choice of investments. The goal has more to do with earning above-average returns than investing in specific assets. So, hedge funds adapt more easily to market movements and tap into market opportunities effectively. 

  • Additional Investment Costs:

Like mutual funds, hedge funds also carry additional investment costs like management fees and performance fees. The management fee is typically levied as a percentage of the Assets Under Management (AUM) in the fund’s portfolio. The performance fee, on the other hand, is levied as a percentage of the profits earned. 

  • Leveraged Investments:

Hedge funds also typically rely on leveraged investment strategies to take large positions in the market with a small capital outlay. This is possible because the rest of the money is borrowed from the brokerage partner. While leveraged positions may generate substantial returns, the risk in such positions is also enhanced exponentially. 

  • Inbuilt Risk Management:

True to their name, hedge funds adopt inbuilt hedging strategies to manage the high downside risk that comes from the aggressive trading techniques they adopt. The complex risk management models in hedge funds involve offsetting potential losses in the core mix of assets by taking contrarian positions in other related but opposite asset or asset classes. 

  • Unregulated Investments:

Unlike mutual funds and other securities and stocks, hedge funds do not fall within the purview of the Securities and Exchange Board of India. So, fund managers handling these alternative unregulated investments generally have more freedom to implement aggressive investment techniques. However, on the flip side, this increases the risk for investors. 

Different Types of Hedge Funds

Depending on the primary assets in focus, hedge funds can be grouped into different categories, as outlined below. 

  • Equity Hedge Funds

These hedge funds primarily focus on domestic and global equity markets. They typically take long positions in the stocks of companies that are expected to perform exceptionally well over time. Conversely, they may also hedge their positions by going short in the stocks of companies that they expect will perform poorly in the foreseeable future. This mix of long and short positions allows such hedge funds to exploit both sides of the equity market. 

  • Global Macro Hedge Funds

Global macro hedge funds aim to profit from significant market movements that follow a major economic, political or socio-economic event. For instance, a fund manager may invest in certain stocks, securities and even non-securities that may perform well following a major policy reform or a change in interest rates. Conversely, if some assets are expected to fall after such events, hedge funds may take short positions in those assets. 

  • Activist Hedge Funds

Fund managers of activist hedge funds aim to influence the policies and stock prices of the companies in which they invest. So, they purchase significant stakes in such entities and then encourage the management to adopt financial or managerial measures to boost the stock price in the near future. 

  • Relative Value Hedge Funds

Relative value hedge funds attempt to profit from the minor differences in the relative or perceived value of different related securities. These funds try to leverage the price differentials by selling and buying such securities simultaneously in large quantities, so the profits, if any, are multiplied. 

Hedge Fund Investment Strategies

Hedge funds adopt a mix of complex and common investment strategies to achieve their primary goal of delivering substantial positive returns. Some such strategies include the following: 

  • Long and Short Selling:

This involves a mix of long positions in some securities and non-securities and short positions in other assets that act as a hedge. 

  • Market-Driven Strategies:

Here, hedge funds analyze overall domestic and global market trends before implementing strategies to take advantage of anticipated market movements. 

  • Market Neutral Strategies:

These strategies can be useful when there is little to no clarity about how the market may move. They are designed to lead to profits (or at least reduce losses) irrespective of the market move.

  • Arbitrage Strategies:

Arbitrage strategies allow hedge funds to take advantage of the difference in the prices of the same asset in two different markets. 

The Bottom Line: Returns vs Risks in Hedge Funds

From the above-mentioned details about the meaning of hedge funds, how they work and what their key features are, it is easy to deduce that these funds are highly risky avenues. The lack of regulatory oversight further increases the risk. That said, if a hedge fund’s strategies are successful, the returns may far outweigh the gains from most other market-linked assets. Before investing in hedge funds, investors must weigh both the risks and returns objectively and make a decision.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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