Hedge Fund

A hedge fund is a lightly regulated pool of funds where a fund manager has flexibility in their investment strategies. Hedge fund managers are not constrained by the rules that apply to mutual funds or commodity funds.

They can take short positions, use derivatives for leverage and speculation, perform arbitrage transactions (which exploit price differentials in different markets or exchanges to make a profit), and invest in almost any situation in any market where they see an opportunity to achieve positive returns.

Hedge fund managers have tremendous flexibility in their strategies; their ability to select superior investments within the targeted strategy and relevant markets is more important for hedge funds than for almost any other managed product.

Marketing Strategy of Hedge Funds

Hedge funds are heavily marketed on their historical performance. Many hedge funds claim to offer higher returns with less risk than traditional investments and a low correlation to stocks and bonds. In some cases, this may be true, but in many others, it may not. Investors must remember that there is no guarantee that history will repeat itself.

They should also consider the short history of these products compared to stocks and bonds. Many hedge funds have existed for less than 10 or 15 years and have not experienced an entire investment cycle. This may reduce the significance of historical data, making it hard to separate actual manager skill from luck and to make valid inferences about future performance.

Comparison between Hedge Fund and Mutual Fund

A hedge fund may look similar to a mutual fund in construction, like pooling investments from different investors, but it has distinct features from a mutual fund. Let’s understand some of these features below:

Hedge Fund Strategies

Hedge funds can generally be classified into three major categories based on their strategies and in order of increasing expected return and risk: –

• Relative value,
• Event-driven,
• Directional

Relative Value Strategies

Relative value strategies attempt to profit by exploiting inefficiencies or differences in pricing related to stocks, bonds, or derivatives in different markets. Hedge funds using these strategies generally have low or no exposure to the underlying market direction. Instead, their returns are due to the manager’s skill in identifying mispriced securities and other instruments and implementing arbitrage trades.

Event-Driven Strategies

This strategy seeks to profit from unique events such as mergers, acquisitions, stock splits, and stock buybacks. Hedge funds that use event-driven systems have medium exposure to the underlying market direction. Therefore, the manager focuses on assessing the implications of specific events and on the timely implementation of market positions designed to profit from the most likely outcome of the event.

Directional Strategies

Directional strategies bet on anticipated movements in equities, debt securities, foreign currencies, and commodities market prices. Hedge funds using these strategies have high exposure to trends in the underlying market. The manager predicts and understands the opportunities generated by movements in different market indicators. The manager then focuses on establishing positions designed to take advantage of the most likely direction in these indicators. The effects of the manager’s skill can be magnified through leverage.

Hedge Fund Risk Drivers

Any investment strategy that targets a return more significant than the return on short-term Treasury bills (i.e., risk-free return) involves some risk. There are many sources of hedge fund risk, and below, we discuss what differentiates first-order risk (or directional risk) from second-order risks (such as liquidity risk, default risk, and leverage risk) and the third category of risk not explicitly related to the hedge fund’s strategies, operational risk. First-order and second-order risks are used to classify risks associated with a hedge fund’s investments and trading processes. These risks directly affect the overall risk and return of hedge funds.

First Order Risk

This risk refers to exposure to changes in the general direction of interest rates and equity, currency, and commodity markets. The source of risk is market-induced or systematic (which cannot be reduced through diversification). First-order risk does not affect relative value strategies or event-driven strategies to any significant degree. However, it affects directional strategy based on a hedge fund manager’s views about the direction of different markets, interest rates, commodity prices, and currencies.

Second-Order Risks

It includes liquidity, leverage, deal-break, default, counterparty, trading, concentration, pricing model, security-specific, and trading model risks. These risks, unlike first-order risk, are not related to the market but to other aspects of trading, such as dealing, implementing arbitrage structures, or pricing illiquid or infrequently valued securities.

Operational Risk

The third type of risk, operational risk, relates to the hedge fund as a business entity and stems from the fact that many hedge funds are small, newly created businesses that depend on one or more high-profile managers for their success. Such organizations are highly focused on promoting and supporting the skills of the fund managers. As a result, they may lack the organizational depth, managerial talent, and strategic planning capabilities necessary to ensure growth or survival. For most hedge funds, the operational risk stems from potential system failures and faulty settlement, reporting, and accounting procedures. Operational risk is significant in single-strategy funds and needs to be addressed through due diligence.

It is important to note that in India, there is no specific regulation for hedge funds. However, they are classified under the AIF Category III Fund (Alternate Investment Fund), as they use complex investment strategies, including leverage trading and derivatives.

Bottomline: A Pooled Investment Fund for High Net Worth Investors Only

Hedge funds pool money from investors and invest in securities or other investments to get positive returns. Hedge funds are not regulated as heavily as Mutual Funds ETFs and generally have. Generally, they have mutual funds to pursue investments and strategies that may increase the risk of investment losses. As a result, hedge funds are limited to wealthier investors who can afford the higher fees and risks of hedge fund investing and institutional investors, including pension funds.