Introduction

A hedge fund is a privately managed pooled investment fund that uses diverse and complex strategies to earn high returns for its investors. Hedge funds are designed to hedge against market volatility by investing in a wide range of asset classes, including equities, debt, derivatives, commodities, currencies, and more. These funds aim to generate absolute returns, meaning profits in both rising and falling markets.

However, hedge funds are not accessible to all investors. They are typically open only to institutional investors, high-net-worth individuals (HNIs), and qualified purchasers, due to their higher risk, complex structure, and regulatory requirements.

In India, hedge funds fall under the category of Alternative Investment Funds (AIFs - Category III), regulated by the Securities and Exchange Board of India (SEBI).

What Is a Hedge Fund?

A hedge fund is an investment vehicle that pools capital from a select group of investors and employs non-traditional, often aggressive strategies to generate returns. Unlike mutual funds or ETFs that aim to outperform benchmarks, hedge funds are performance-driven and often charge higher fees, including a performance fee on profits.

Key Characteristics of Hedge Funds:

• Flexibility in Investment Choices: Can invest in a wide array of instruments, including leveraged and derivative products.
• Aggressive Strategies: May use short-selling, arbitrage, leverage, and derivatives to profit from market movements.
• Limited Access: Mostly available to wealthy investors or institutions.
• Active Management: Fund managers often take a hands-on approach and are incentivized through profit-sharing.

For example, a hedge fund may simultaneously buy undervalued stocks and short-sell overvalued ones, aiming to generate returns regardless of the overall market trend.

Purpose of a Hedge Fund

The core idea behind a hedge fund is to minimize risk (hedge) while maximizing returns through diverse strategies. Although initially built to hedge against market downturns, most modern hedge funds are return-seeking investment vehicles.

• Hedge funds may use strategies such as:
• Market Neutral – Balancing long and short positions to neutralize market risk.
• Global Macro – Betting on macroeconomic trends like interest rates, inflation, or currency movements.
• Event-Driven – Investing based on corporate events like mergers, acquisitions, or bankruptcies.
• Distressed Assets – Buying undervalued or troubled companies with turnaround potential.

Hedge Funds in India

In India, hedge funds are structured under Category III Alternative Investment Funds (AIFs), as per SEBI’s AIF Regulations, 2012. These funds are permitted to employ leverage and engage in complex trading strategies, similar to global hedge funds.

Features of Indian Hedge Funds:

• Minimum investment requirement: ₹1 crore per investor.
• SEBI-regulated: All hedge funds must be registered and comply with disclosure and valuation norms.
• Targeted at HNIs and institutional investors.
• Tax treatment varies depending on the strategy and structure of the fund.
• Examples of hedge fund managers in India include Avendus Capital, Edelweiss Alternative Asset Advisors, and IIFL Wealth.

Growth of Hedge Funds Globally and in India

Hedge funds have seen significant growth globally, with assets under management (AUM) running into trillions of dollars. In India, while the segment is still relatively niche, the rise in HNI population and increasing awareness about alternative investments have led to strong interest in hedge funds, especially post-2020.

Key factors fueling growth:

• Increased market volatility.
• Investors seeking non-traditional returns.
• Enhanced regulatory clarity through SEBI’s AIF framework.

Advantages of Hedge Funds

1. Diversification

• Hedge funds invest across asset classes, markets, and strategies, reducing portfolio concentration.

2. Potential for Higher Returns

• With flexibility in investment approach, hedge funds aim to outperform traditional investments.

3. Downside Risk Mitigation

• Many hedge funds aim to deliver positive returns even during bear markets, through hedging techniques.

4. Professional Management

• Managed by experienced fund managers who use research, data analytics, and market timing strategies.

Disadvantages of Hedge Funds

1. High Fees

• Typically follow a “2 and 20” model: 2% management fee + 20% of profits as performance fee.

2. Limited Liquidity

• Investors may face lock-in periods and limited redemption windows.

3. Higher Risk Exposure

• Use of leverage and speculative strategies can amplify losses.

4. Accessibility Barriers

• High minimum investment thresholds make them inaccessible to retail investors.

5. Regulatory Scrutiny and Controversies

Globally, hedge funds have been involved in market manipulation cases and high-profile collapses, raising concerns about transparency and systemic risk.

Conclusion

Hedge funds represent the cutting-edge of modern investment strategies, designed to deliver non-traditional returns using innovative and often aggressive approaches. In India, they are still evolving but are increasingly gaining interest among high-net-worth investors and institutions looking to diversify beyond equity and debt.

While hedge funds offer potential for superior returns, they come with high costs, complex structures, and elevated risks, making them unsuitable for the average investor. For those who qualify and understand the risk, hedge funds can play a strategic role in an alternative investment portfolio.