We often hear the term “hedge fund”. Many business news papers and TV channels in India blame hedge funds whenever the stock market falls. So, what are hedge funds? How do they work? Do they operate in India? Let’s explore.

Yes, we often hear about them – they are portrayed as the beasts on the Wall Street (or, on Dalal Street, for that matter!) We are always told that they are fickle investors having a herd mentality. They are trigger happy and can sell all their holdings in no time if they sense trouble.

So, what are hedge funds?

Surprisingly, there is no legal definition or classification of hedge funds! Yes, that’s true. So, the only way to understand them is by studying the way they operate, and by examining the differences between hedge funds and traditional funds like (mutual funds).

What is a Hedge Fund?

Most types of funds that deal with money collected from people are regulated in one way or the other. Therefore, all mutual funds, stock brokers, portfolio management services and insurance companies are regulated by a market regulator (For example, SEBI, AMFI or IRDA in India, or SEC in USA).

Hedge funds are funds that are not regulated by any statutory regulating body.

And since they are not regulated, they can invest the way they deem fit – they can invest in innovative securities (like complex derivatives), and they can follow any pattern in asset allocation (they can invest all their money in stocks if they want, can sell it, and invest it all in crude oil futures!).

Why are they called “Hedge” funds?

Hedge funds started out by seeking to offset potential risks in their primary investments by adopting variety of methods for hedging. (This primarily included short selling). Therefore, the funds were called “hedge” funds.

But these days, most funds do not have a primary investment that they have to protect. These funds take positions directly in hedging instruments (like short selling and derivatives) to benefit solely from price movement.

Thus, instead of using hedging instruments for “hedging”, hedge funds today use these instruments for “speculating”.

How does a Hedge Fund work?

The age old belief of the markets is that the higher the risk, the higher is the potential return. Hedge funds maximize their risks, there by aiming to maximize their returns.

And how is the risk increased? By having naked positions (that is, uncovered open positions) in derivative markets, by being highly leveraged, by investing in sub prime debt and commodities, etc.

(If these terms are not familiar, don’t worry – they are explained in detail later).

Thus, the hedge funds use hedging instruments to increase risk instead of decreasing it!

How is a Hedge Fund different from traditional funds like Mutual Funds?

The only similarity between hedge funds and mutual funds is that both types of funds collect money from a group of people, and invest to earn a profit.

But there are several differences – and these help us understand hedge funds better. Here they are:

Risk

As we have seen, hedge funds thrive on risk. They take up risky strategies in order to maximize their returns.

On the other hand, traditional funds are highly risk averse, and usually follow a long-only strategy. That is, they buy assets, hold them for some time with the intention of making a profit, and then sell them.

Type of return (Alpha)

Most traditional funds have a benchmark against which their return is judged. Thus, if a fund performs better than its benchmark (or “beats” the benchmark), it is supposed to have performed well.

For example, let’s say a fund’s benchmark in the Sensex. If the Sensex rises by 6%, and the fund rises by 8%, it beats the Sensex, and is said to have performed well. (This is also called “outperforming” the benchmark).

The problem is, if the Sensex falls by 6%, and the fund falls by 4%, even then, it outperforms its benchmark, and the performance is supposed to be satisfactory.

Hedge funds question this logic. They ask – how can performance be satisfactory when the investor actually loses money?

And therefore, they aim for absolute positive return, irrespective of the market movement. This is also sometimes referred to as Alpha – the return over and above the general return in-line with the market.

Leverage

Traditional funds collect money from people, and invest only that money in the market to generate returns.

Hedge funds use leverage. They invest a lot more than their corpus by taking on debt.

Leverage increases returns – both positive and negative – by a large factor.

For example, say you have Rs. 100. You invest it in a stock, and get a 10% return. Thus, you now have Rs. 110. Your return is Rs. 10 on Rs. 100 invested = 10%.

Now, say you borrow Rs. 200 using this Rs. 100 that you have. You invest this total of Rs. 300, and get the 10% return. Thus, you end up getting Rs. 330.

But now, you return is Rs. 30 on the original Rs. 100 that you had – it has jumped to 30%! (It would be slightly less than 30% if we also take into account the interest paid on the borrowed amount).

The same would happen in case of a loss as well – even a loss would be equally magnified.

Hedge funds make full use this strategy – they go for very high leverage, and invest all the money in the hope of generating spectacular returns.

Type of investors

Since the hedge funds follow an extremely risky philosophy, they are not suitable for small investors. These are meant for large, seasoned investors who are expected to understand the risks being undertaken by these funds.

For example, in the US, an individual should have a minimum net worth of US $1,000,000 (US $1 Million) or a minimum income of US $200,000 in each of the last two years if he / she wants to invest in a hedge fund.

(Please continue reading on Page 2 for more differences between Hedge Funds and traditional funds, plus information on Hedge Funds in India and around the globe.....)

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