The interest of the ultra-high net worth individual (UHNI) in hedge funds
has been on the rise. By March 2017, the wealthy had commitments worth Rs 10,078.8 crore to these funds
from mere Rs 22.5 crore in December 2012.
give the wealthy an option to invest in strategies that other equity products like mutual funds
and portfolio management services (PMS) cannot. Depending on the market condition, for example, these funds
can take high cash calls if they think the markets are overvalued. They can even leverage their base portfolio up to two times if they see an opportunity. Mutual funds
are not allowed to go for leverage.
They are more flexible:
in India are classified as Category III alternative investment funds
(AIF). They can be structured as closed-ended or open-ended. These funds
invest in listed equities with a lot more flexibility on the stock or sector exposure limits that mutual funds
face. The wealthy invest in them to build a more focused or concentrated exposure to specific themes that may not be permissible in other regulated investment
vehicles. They, therefore, have the flexibility to deploy alternative strategies that have a potential of enhancing yield. The strategy of leverage or hedging, over a period, can improve upside participation while minimising downside risk.
also help the UHNIs to diversify their portfolio. As they have large portfolios, these individuals need to have diversification of strategy, too.
Unlike those in the US:
in developed matured markets like the US generate absolute returns for investors without restrictions on what to invest in and where to invest. Such funds
usually make use of derivatives and even borrow or leverage to enhance potential returns. The managers of such funds
are mandated to go all out to deliver returns without the shackles that saddle most traditional investment
Those hedge funds
achieve this by trading a range of strategies across available asset classes — equities, commodities, currencies, debt and a range of financial instruments — futures, options, swaps, forwards and other derivatives.
The flip side of such strategies is the enhanced tail risk and can even wiping off entire corpuses when extremely unexpected events transpire. While the probability of such events are low but the magnitude of loss can be high. But the US Securities and Exchange Commission
have introduced sweeping reforms clamping down hedge funds
restrictions, registration and disclosure requirements.
Different than mutual funds, PMS:
are the most closely regulated with detailed watertight rules governing almost every aspect of investment
since such funds
are open for investment
by retail investors. PMS
catering to larger high networth investors (HNI) have a minimum investment
limit of Rs 25 lakh. No short selling or leverage/borrowing are permissible in mutual funds
and a PMS.
A category III fund has a minimum investment
limit of Rs 1 crore with no restrictions that are imposed on a PMS
or mutual funds.
don’t even have benchmarks to follow or beat. Since PMS
and mutual fund performances are compared to benchmarks, the propensity to raise cash levels are low. In hedge funds, it’s entirely manager’s call to decide on the cash levels.
and mutual funds
follow benchmark, their returns also reflect the movement of the underlying index. When markets rise, so do the returns and vice versa. Hedge funds
in the country are structures in such a way that they may not give returns at par with major indices but they don’t even crash as much when market correct.
or mutual funds
face pressure to be fully invested even if they feel that markets are overvalued. As hedge funds
don’t have such restrictions, they can keep cash and wait for markets to correct or reach a comfortable valuation level.
When you apply for an initial public offering through a PMS, you are classified as an HNI. It is because, the investments
are not pooled. Investors have separate accounts. The HNI category is usually highly oversubscribed during the IPOs. But in case of hedge funds, the investors are placed in the institutional investors category as it is pooled investment.
The fund, therefore, has better chances of getting the stock in an IPO.
In category III funds, a fund manager also has drawdown option. It means, he can ask for the committed funds
when he sees an opportunity.
A category III AIF
has fee structure similar to that of a PMS
product. When an investor signs up with them, they charge up to 2 per cent as a set-up fee. It can be lower if the investment
amount is large. Then, there’s fund management fee of up to 2 per cent. There’s also performance-linked fee of up to 20 per cent.
Selecting a hedge fund:
Investors wanting to sign up with a hedge fund need to thoroughly evaluate certain parameters before taking the plunge. The metrics for evaluating a hedge fund are different from those for mutual funds
In case of hedge fund, the manager’s skill and risk management is a much bigger part of the evaluation process.
One also needs to check the extent of leverage that the fund will employ. In hedge fund strategies, there is a great temptation to keep scaling up leverage to get higher returns. But a good hedge fund manager will push back and maintain a reasonable level of leverage or gross/net exposure.
Regulations have always ensured that the negative or undesirable aspects witnessed in offshore hedge funds
should not manifest in the Indian investing landscape. The higher minimum investment
amount ensures participation only among a handful of sophisticated experience UHNI, who have the ability to understand the product they are signing up for.
The writer is managing partner and head - family office, ASK Wealth Advisors