What are Hedge Funds? AIFs Explained!


Have you ever wondered what hedge funds are and why they keep making headlines in the world of finance? While the term "hedge fund" may sound complex, fear not, because we're here to break it down in the simplest way possible. In India, hedge funds are known as Alternative Investment Funds (AIFs). In this article, we will understand what hedge funds or AIFs are and their characteristics. We will also explore the different types of hedge funds.

What are Hedge Funds?

A hedge fund is a pooled investment vehicle like a mutual fund. However, there's a key difference – hedge funds are private and not open to everyone like mutual funds are. Hedge funds are distinguished by their investment approach rather than the underlying investments. They combine traditional debt and equity instruments with leverage, derivatives, short selling, and other strategies to generate and enhance their returns. The objective of a hedge fund is to generate high returns.

Hedge funds are typically structured as limited partnerships or trusts. These funds have a dedicated professional fund manager who assumes the role of a general partner (GP) in the partnership. The rest of the investors will be Limited Partners (LPs) in the fund. The GP will have comparatively less investment in the fund. 

Hedge Fund Fees or Charges

The General Partner is entitled to management fees and performance fees. The percentage of fees depends on the individual fund, however, "2 and 20" is a common fee structure among hedge funds. In a "2 and 20" structure, the fund manager charges a 2% management fee annually on the Asset Under Management (AUM) and a 20% performance fee on the profits generated. A "1 and 10" fee structure is also common, wherein a 1% management fee and 10% performance fee are charged.

Characteristics of Hedge Funds

Here are a few characteristics that set hedge funds apart from other asset managers:

Investment in Alternative Assets

Traditional investments usually involve buying and holding publicly traded stocks and bonds for the long term. On the other hand, alternative investments are a bit more diverse. They can include both long positions (buying assets with the hope they'll increase in value) and short positions (betting that assets will decrease in value) in various things like publicly traded and private stocks, debt, commodities, currencies, and financial contracts (derivatives).

Hedge funds typically invest in alternative assets although they can invest in traditional assets. However, it's important to note that investing in these alternative assets can be riskier compared to the more conventional investment options.

Short Positions

Hedge funds have a unique advantage over mutual funds– they can engage in short selling of securities and other assets. This means that they can bet on the value of an asset going down. In contrast, mutual funds cannot short securities due to the risk of potentially incurring unlimited losses. When you take a short position, the chance of losing your entire investment is higher, making it riskier compared to traditional investing where you hope the value of assets will rise.

Private Ownership

Hedge funds operate as privately owned entities, organized in the form of partnerships or trusts. Unlike many other investment firms and asset management companies that are usually publicly traded and welcome external investors, hedge funds have a more exclusive setup.

In a hedge fund, you'll typically find a small group of wealthy individuals, often referred to as ultra high net-worth individuals (UHNIs) or high net-worth individuals (HNIs), along with a professional fund manager. These funds usually have restrictions on allowing outside investors to join in. However, they may occasionally permit the addition of new investors as long as it aligns with the terms laid out in their partnership agreement.

Complex and Aggressive Strategies

Hedge funds deploy complex investment strategies such as arbitrages. These complex strategies demand substantial capital commitments and often involve extended periods during which investors must keep their money locked into the fund.

Less Legal & Regulatory Constraints

Hedge funds are not subject to the same strict rules and regulations as other types of investment funds, such as mutual funds. This is because hedge funds are generally considered to be sophisticated investments that are only suitable for accredited investors. Accredited investors are individuals or institutions with a high net worth or income, and they are assumed to be able to understand and bear the risks associated with hedge fund investing.

Types of Hedge Funds

Hedge funds are typically classified by strategy. A general classification includes five broad categories of strategies:

Equity Hedge Funds

Equity hedge funds are actively involved in the public equity markets, where they engage in both long and short positions. They bet on some stocks to go up and others to go down. Many of these equity hedge strategies follow a "bottom-up" approach, which means they start by thoroughly analyzing individual companies. After that, they move on to assessing the specific industry the company belongs to and then take a broader view by analyzing the overall market. The goal is to maintain a relatively balanced mix of long and short positions to manage risk and seek returns.

Event-Driven Hedge Funds

The even-driven strategy also uses a bottom-up approach and seeks to profit from defined events that are expected to change valuations. These strategies focus on identifying and capitalising on specific events that have the potential to impact a company's valuation significantly. These events can include things like acquisitions, corporate restructurings, or other major developments that can influence how the market values a company.

Event-driven strategies often include a mix of long and short positions in various financial instruments, including common and preferred stocks, debt securities, and options. The objective is to strategically position investments to take advantage of the expected changes in valuations resulting from these significant corporate events.

Relative Value Hedge Funds

Relative value strategies are designed to capitalize on pricing differences between related securities, particularly when these differences deviate from their typical short-term relationships. The core assumption behind these strategies is that the short-term pricing gap will eventually correct itself. Arbitrage trading, a key component of relative value strategies, involves identifying and exploiting such pricing anomalies to generate profits.

Opportunistic Hedge Funds

Opportunistic hedge funds have a primary focus on macroeconomic events and commodity trading. Their investment strategies revolve around seizing opportunities presented by large-scale economic developments and movements in the commodity markets. In pursuit of their objectives, these funds may frequently employ index Exchange-Traded Fund (ETF) securities and derivatives, to take advantage of these broader market trends.

How Do Hedge Funds Make Money?

Partners in a hedge fund contribute capital with which the fund manager makes investments. The hedge fund generates income through two primary sources:

  1. Management Fees: Clients are charged annual management fees based on the total value of their investments, known as Assets Under Management (AUM). These fees compensate the fund manager for their services and oversight of the fund's investments.
  2. Performance Fees: In addition to management fees, hedge funds often levy a performance fee. This fee is calculated based on the fund's annual returns. It rewards the fund manager when the fund's performance surpasses a specified benchmark or target, aligning the manager's interests with those of the investors.

This helps sustain the operations of the hedge fund, while also incentivizing the manager to strive for strong investment performance.

Hedge Fund Indices

Hedge fund indices indicate the returns achieved by hedge funds. Several research organizations curate databases of hedge fund performance data and consolidate this information into indices. These database indices are designed to depict hedge fund performance either on a wide global scale (representing hedge funds in general) or at a more detailed strategy level. Typically, these indices feature an equal-weighted methodology, which means that they represent the performance of various hedge funds within a particular database without giving more importance to larger funds. This approach provides a snapshot of how hedge funds (both collectively and by strategy) are performing in the market.

You can view the data of Barclays hedge fund indexes here.

Hedge Funds vs Mutual Funds

Although mutual funds and hedge funds share the common goal of investing clients' money to generate returns, they have some significant differences that set them apart. These distinctions can impact the way they operate and the risk and reward profiles they offer to investors. Here are some of the major differences:

Hedge FundsMutual Funds
Risk LevelHigh risk due to non-traditional and complex investment strategiesComparatively low risk
Minimum Investment₹1 croreAs low as ₹100
RegulationRequires only periodic disclosure to investorsSubject to strict regulatory oversight and disclosure requirements.
Investment StrategiesLong and short investments in private and public equities, debt, derivatives, currencies, etcOnly long investments in equities and debt
Short-selling AllowedNot Allowed
InvestorsHNIs, banks, institutionsAny domestic investor
Fund Manager ParticipationThe fund manager has investments in the fundThe fund manager may or may not have investments in the fund

Hedge Fund Taxation

Mutual funds are considered pass-through investments, which means that the income they generate is taxed in the hands of the individual investors, and not at the fund level. This means that investors are personally responsible for reporting and paying taxes on any capital gains, dividends, or interest income they receive from the mutual fund.

On the other hand, hedge funds do not enjoy pass-through tax status. Income generated by a hedge fund is typically taxed at the fund level, often at the fund's own tax rate. This can have implications for how income is distributed to investors and may result in different tax treatment for investors in hedge funds compared to those in mutual funds. It's important to note that tax laws and regulations can vary by jurisdiction, and the specific tax treatment of mutual funds and hedge funds may differ depending on local tax laws and fund structures.

Hedge fund taxation in India falls under tax regulations for Alternative Investment Funds (AIFs). Annual earnings exceeding ₹5 crore are subject to a tax rate of 42.74%.

Examples of Hedge Funds In India

Motilal Oswal’s offshore hedge fund, Munoth Hedge Fund, Quant First Alternative Investment Trust, IIFL Opportunities Fund, India Zen Fund, Edelweiss Alternative Asset Advisors, etc are examples of hedge funds in India.

Hedge funds in India are not as well-known as their counterparts in the United States and other developed countries. This is because the hedge fund industry in India is still relatively new.

Hedge Fund Regulation in India

In India, hedge funds are classified as category III Alternative Investment Funds (AIFs). These funds operate under the Securities & Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

In conclusion, hedge funds are private pooled investment funds. However, it is out of reach for retail investors due to the high capital requirements. High tax implications and a non-pass-through model are also deterrents.

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