What is a Hedge Fund?

Definition of Hedge Fund (HF) 

Hedge funds are alternative investments using pooled funds just like mutual funds that employ numerous different strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

History of Hedge Fund

Former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co. launched the first hedge fund in 1949. He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling (is now referred to as the classic long/short equities model) other stocks. In 1952, Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner.

The first hedge fund was established in the late 1940s as a Long/short hedged equity vehicle. More recently, institutional investors – corporate and public pension funds, endowments and trusts, and bank trust departments—have included hedge funds as one segment of a well-diversified portfolio.+

Characteristic of HF:-

1. They're only open to "accredited" or qualified investors: Hedge funds are only allowed to take money from "qualified" investors—individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence.
2. They offer wider investment latitude than other funds: A hedge fund's investment universe is only limited by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies.
3. Employ leverage: - Hedge funds will often use borrowed money to amplify their returns.
4. Fee structure: - Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee. This fee structure is known as "Two and Twenty"—a 2% asset management fee and then a 20% cut of any gains generated.

Risk associated with HF:

1. Concentrated investment strategy exposes hedge funds to potentially huge losses. 
2. Hedge funds typically require investors to lock up money for a period of years. 
3. Use of leverage, or borrowed money, can turn what would have been a minor loss into a significant loss.

Hedge fund strategies:-

1. Equity Market Neutral: These funds attempt to identify overvalued and undervalued equity securities while neutralizing the portfolio’s exposure to market risk by combining long and short positions.
2. Convertible arbitrage: These strategies attempt to exploit mispricing in corporate convertible securities, such as convertible bonds, warrants, and convertible preferred stock. Managers in this category buy or sell these securities and then hedge part or all of the associated risks.
3. Fixed-income arbitrage: These funds attempt to identify overvalued and undervalued fixed-income securities (bonds) primarily on the basis of expectations of changes in the term structure or the credit quality of various related issues or market sectors.
4. Distressed securities: Portfolios of distressed securities are invested in both the debt and equity of companies that are in or near bankruptcy. Traditional investors prefer to transfer those risks to others when a company is in danger of default.
5. Merger arbitrage: Merger arbitrage, also called ―deal arbitrage,‖ seeks to capture the price spread between current market prices of corporate securities and their value upon successful completion of a takeover, merger, spin-off, or similar transaction involving more than one company.
6. Hedged equity: Hedged equity strategies attempt to identify overvalued and undervalued equity securities. Portfolios are typically not structured to be market, industry, sector, and dollar neutral, and they may be highly concentrated.
7. Global macro: Global macro strategies primarily attempt to take advantage of systematic moves in major financial and non-financial markets through trading in currencies, futures, and options contracts, although they may also take major positions in traditional equity and bond markets.
8. Emerging markets: These funds focus on emerging and less mature markets. Because short selling is not permitted in most emerging markets and because futures and options may not available, these funds tend to be long.
9. Fund of funds: A fund of funds (FOF) is a fund that invests in a number of underlying hedge funds. A typical FOF invests in 10-30 hedge funds and some FOFs are even more diversified. Although FOF investors can achieve diversification among hedge fund managers and strategies, they have to pay two layers of fees: one to the hedge fund manager, and the other to the manager of the FOF. FOF are typically more accessible to individual investors and are more liquid.

Hedge fund as an AIF-Category III in India

The AIF Regulations make it mandatory to obtain a certificate of registration from SEBI for enabling AIFs to operate under one of the following 3 categories:

• Category I – AIFs which invest in start-up or early stage ventures or social ventures or SMEs or infrastructure. It includes venture capital funds, SME funds, social venture funds, infrastructure funds, angel funds, etc.
• Category II – AIFs, which do not fall in Category I or Category III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements. Includes private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other regulator.
• Category III – AIFs, which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. Includes hedge funds or funds, which trade for short term returns, or open ended funds, for which no specific incentives or concessions are given by the government or any other regulator.