How hedge funds make money for HNIs

These funds give the wealthy an option to invest in strategies that other equity products like mutual funds and portfolio management services cannot, says Nishant Agarwal.

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.

These funds 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 and PMS are not allowed to go for leverage.

1. They are more flexible

Hedge funds 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 or PMS 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.

Hedge funds also help the UHNIs to diversify their portfolio.

As they have large portfolios, these individuals need to have diversification of strategy, too.

2. Unlike those in the US

Hedge funds 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 managers.

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 with investment restrictions, registration and disclosure requirements.

3. Different than mutual funds, PMS

Mutual funds 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. Hedge 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.

As PMS 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 structured 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.

Most PMS 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 in PMS 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.

4. Fee structure

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.

5. 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 and PMS.

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.

Nishant Agrawal is managing partner and head -- family office, ASK Wealth Advisors.

Photograph: Reuters