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Ramesh Pathania/Mint
Ramesh Pathania/Mint

De-jargoned: hedge fund

They are similar to MFs in the sense of being investment vehicles which pool investors' money

Still at a nascent stage in the Indian market, a hedge fund is a popular product overseas to generate absolute returns by investing across assets. Given the volatility in the global markets, its popularity has only increased as it does not conform to a specific strategy.

How does it work?

Hedge funds are similar to mutual funds (MFs) in the sense of being investment vehicles which pool investors’ money. This is then invested as per the funds mandate and returns are distributed among unit holders. But the similarity ends there. Hedge funds use strategies far more complex than a typical MF which mostly focuses on generating returns within one asset class or through simple asset allocation. Hedge funds use various strategies such as long-short, derivatives, leverage and so on and aim to give a level of absolute return with minimum risk. They are dependent on statistical tools and models to build portfolios. There are hedge funds which could also concentrate on one particular asset, others such as macro funds can invest across the spectrum in equity, fixed income, commodities and currencies. The funds are managed very actively and there could be a number of transactions in a day. The idea is to invest where the near term opportunity is and take profit as soon as that opportunity fizzles out. At the same time, as the name suggests, hedge funds seek to minimize risk. However, given that in many hedge funds there is leverage involved, the risk can sometimes get amplified when there is uncertainty or nervousness in the financial markets.

Benefits and Risks

This is really a product meant for the sophisticated investor. Last year, the Securities and Exchange Board of India (Sebi) issued guidelines under the alternative investment fund (AIF) structure to govern hedge funds. These clearly specify a minimum investment of 1 crore in such funds. So while it is a good tool for diversification, the product itself is complex and should be used only by high net worth individuals (HNIs) who understand its nuances. Hedge funds are also not restricted by geography which means they can invest in assets across the globe. But this also increases the risk as external factors which impact asset values across countries can be hard to predict and manage.

The Indian Context

In India, hedge funds can register under category III of AIFs with Sebi. So far there are 15 such funds registered with Sebi. Being registered with the regulator implies there is a regulatory cover for investors. This means the product structure has to be as prescribed, and it is monitored and audited. This also means that investors can approach the regulator for any grievances. It is early days for this product and experts suggest there is interest among HNI investors. However, before committing large sums they are watching the performance play out for some time.

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