HEDGE FUNDS

A hedge fund is a private investment fund that charges a performance fee and is typically open to only a limited range of qualified investors
In the US, in order for an investment fund to be exempt from direct regulation, it must be open to only a limited number and accredited investors
Due to lack of regulation that otherwise apply to mutual funds, brokerage firms or investment advisers can invest in more complex and more risky investments(complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage) than a public fund might
As the name implies, HFs hedge the risk of potential loss using a variety of methods, most notably short selling, but they may not apply to funds that hedge their investments
Being outside the regulatory regime(that applies to retail funds), HFs have acquired a reputation for secrecy.
The assets under management of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage.


Hedge fund activity in the public securities markets has grown substantially as it constitutes approximately 30% of all U.S. fixed-income security transactions, 55% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, as well as 30% of equity trades. Hedge Funds dominate certain specialty markets such as trading in derivatives with high-yield ratings, and distressed debt

Difference from Mutual Funds

Unlike mutual funds, however, hedge funds typically take long and short positions in assets to lower portfolio risk arising from broad market movements. How?
A hedge fund may take long positions in certain stocks, and short positions in certain other stocks such that their portfolio beta is close to zero. A beta close to zero means that the portfolio will remain relatively unchanged due to the broad market movement. Such a portfolio will primarily change if the stocks move more than the broad market

Consider, for instance, Hero Honda and Bajaj Auto. The hedge fund may buy Bajaj Auto and short Hero Honda, such that the portfolio beta is close to zero. Suppose Bajaj Auto moves up by 10 per cent, and Hero Honda and the broad market move up by 7 per cent. The fund's net gain is 3 per cent. This is because Bajaj Auto outperformed the market, precisely what the hedge fund was betting on when it constructed the portfolio.
In short, hedge funds generate security-specific returns, and attempt to lower market risk. Notice that a mutual fund would have gained 10 per cent if it had invested in Reliance.
To improve their security-specific returns, hedge funds leverage their portfolio. The fund may collect, say, Rs 100 crore from investors, borrow Rs 50 crore, and invest Rs 150 crore.
In the above instance, an unleveraged fund may have gained only 3 per cent of Rs 100 crore. But a hedge fund that has borrowed Rs 50 crore will gain 3 per cent on Rs 150 crore less interest cost on Rs 50 crore.



Hedge fund risk
Investing in HFs can be a riskier proposition than investing in a regulated fund, despite the traditional notion of a "hedge" being a means of reducing the risk of a bet or investment. HFs have following charateristics :

Leverage : a HF will typically borrow money, with certain funds borrowing sums many times greater than the initial investment. Eg HF will borrow $9 for every $1.So loss of 10% will wipe out complete investment.
Short Selling
Appetite for risk : Investments that carry high degrees of risk, such as high yield bonds, distressed securities and CDOs based on sub-prime mortgages.
Lack of Transperency : Difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision.
Lack of Regulation : HFs are not subject to as much oversight from financial regulators, and therefore some may carry undisclosed structural risks.


Investors in hedge funds are willing to take these risks because of the corresponding rewards. Leverage amplifies profits as well as losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns; secrecy helps to prevent imitation by competitors; and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis.

Open-ended nature
Hedge funds are typically open-ended, in that the price of each share being NAV per interest/share. To realise the investment, the investor will redeem the interests or shares at NAV prevailing at that time. Therefore, if the value of the underlying investments has increased (and the NAV per interest/share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Investors do not typically trade shares among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund, which has a limited number of shares which are traded among investors, and which distributes its profits.


Listing : HFs often list their shares on smaller stock exchanges in the hope that the low level of quasi-regulatory oversight will give comfort to investors and to attract certain funds, such as some pension funds, that have bars or caps on investing in unlisted shares. Shares in the listed HF are not traded on the exchange, but the fund’s monthly NAV and certain other events must be publicly announced there.