Hedge Funds: Types & Strategies

As funds for investment go, everyone seems to know and talk about mutual funds. Mutual funds are financial instruments that pool the cash of investors into a fund that invests in different financial securities such as equity, debt instruments, and more. Hedge funds are also pooled investments. However, the difference between a hedge fund and a mutual fund stops there.  

Nonetheless, this article is not about the difference between a hedge fund and a mutual fund, although you will discover what the difference is when you get familiar with the concept of a hedge fund. Hedge funds may not have gained much popularity in the Indian investment frontier, as they are potentially tied to more risk than other funds, like the ever-popular mutual funds. However, as an investor you should know what hedge funds are, their types, and the different strategies used to make gains with a hedge fund as it may, one day, be your choice of investment.  

What is a hedge fund? 

The main regulatory authority of the financial markets in India, the Securities & Exchange Board of India (SEBI) has defined and described a hedge fund. To use some of the terms and words of SEBI, a hedge fund (which may include a fund of funds) is an “unregistered private investment partnership, pool or fund” that could potentially conduct trading and investment activities in various markets using an array of strategies and instruments. The securities that a hedge fund may invest in may comprise equity (stock), derivatives, debt instruments, and more. Furthermore, a hedge fund is not governed by the regulatory and lawful requirements that mutual funds are subjected to.  

Simply put, a hedge fund is a partnership between accredited and institutional investors that pool their wealth in a fund that invests in a range of assets. As described by SEBI, a hedge fund falls under the umbrella of an “alternative investment”. The fund is managed by a fund manager. Contrary to other financial funds, a hedge fund employs advanced investment techniques and takes short positions, uses leverage, and employs hold long/short positions while trading in derivatives vehicles.  

Before getting into knowing how hedge funds work and hedge fund strategies, it is important to note that Indian hedge funds do not have to be registered or authorised by the Securities & Exchange Board of India. Furthermore, they do not have to disclose their Net Asset Value or NAV at the close of every trading day. In contrast, mutual funds in India must be authorised by SEBI and are mandated to disclose their NAV at the close of a trading day.  

How do hedge funds work? 

Hedge funds work by employing a variety of trading techniques as they invest in an array of securities and assets. Typically, a hedge fund will invest in equity, debt, or derivatives, or a combination of two of these instruments. When a hedge fund invests in a derivative, it usually involves futures and options contracts.  

The way that a hedge fund operates is by pooling the money from several investors into a single fund that invests in an amalgamation of securities. In a hedge fund, the money from large investors such as high net worth individuals (HNIs), banks, endowments, commercial corporations, and pension funds. Hedge funds lie in the group of Alternative Investment Funds - Category III (AIF - III).  

These funds have the reputation of high-end funds, and they trade at high stakes in domestic markets and global financial markets. Hedge fund investing is not for the potentially risk-averse investor and may not be considered by senior citizens who look for more security in investment. As they require a great deal of investment from investors, and invest in premium securities in almost all investment assets, they are considered somewhat riskier than other financial investment instruments, such as mutual funds, for instance.  Additionally, these are unregulated funds so those with surplus cash can afford to invest, rather than more conservative investors.  

Types of Hedge Funds in the Market 

Essentially, there are four kinds of hedge funds to invest in the market today:  

• Global Macro Hedge Fund: This is the type of hedge fund that takes advantage of macroeconomic variables and certain economic conditions like inflation rates to yield profits from upward and downward trends in the market.  

• Relative Value Hedge Fund: The kind of hedge fund that generates profitable gains by taking advantage of price differences in a mix of securities is the Relative Value Hedge Fund.  

• Activist Hedge Fund: The activist hedge fund invests in specific kinds of company securities that are involved with activities like the restructuring of assets and  cost-cutting measures.  

• Equity Hedge Fund: The equity-focused hedge fund invests in domestic and global stocks that primarily aim to offer security against downturns in the markets by the sale of stock indices and overvalued stocks.  

Common Strategies Used By Hedge Funds 

Hedge funds employ distinctive strategies to optimise the returns from the fund for investors. Hedge fund investors are savvy and experienced individuals who have a firm handle of global and domestic market movements and can manipulate and manage funds so that they prove fruitful for investors. Hedge funds, albeit risky, result in portfolio diversification as they reach a broader market to invest in. Furthermore, any hedge fund employs clever and tactical strategies to achieve the successful outcome of the fund for investors. Here are the key hedge fund strategies that may be employed by fund houses:  

• Strategies that are Event-Driven: Strategies that aim to make returns from price changes that are inefficient because of certain corporate events, mergers and acquisitions, corporate restructuring, spin-offs, asset sales, bankruptcies, and other negative events are known as event-driven strategies. The hedge fund manager leverages these events to gain returns.  

• Arbitrage-Focused Strategies: These strategies work with the goal of gaining returns from discrepancies in prices between securities that are connected. Since price differences are expected to be resolved over a period, the prospect to make returns exists.  

• Hedging Equity Strategies: A hedge fund manager may use this kind of strategy to aim for profits by taking long or/and short positions in the markets, especially in those of derivatives markets and equity markets. 

• Macro Market Strategies: These are strategies to make gains from international economic events and financial trends like changes in interest rates, fluctuations in currency, shifts in political domains, and other such circumstances. The fund house takes this strategy into action by the acquisition of holdings with negative or positive exposure to events of a macro nature. Macro strategies are woven around projections and predictions involving macro events and circumstances.  

Conclusion 

The bottom line of hedge fund investing is that it may be considered a risky prospect, requiring a relatively large investment initially. Therefore, it may be considered by individuals with a high net worth or for those investors who have a high tolerance for risk. Before investing in a hedge fund, it may be worth doing some research into the fund, as you do with all your investments. Furthermore, some strategies may be applied while you are investing in a hedge fund, and these involve debt and equity instrument investments, commodity securities, derivatives, real estate, and currencies. Finally, hedge funds in the Indian investment realm are yet to achieve popularity as regulations must arrive in place first.