“Higher the risk, higher the return; lower the risk, lower the Return”. This is the first concept of Investment you come across whether you are a seasoned investor or a newbie while talking to any adviser or participating in any investors’ education programme.
For many years, investors have been told that risk and return are correlated. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return trade-off is the balance between the desire for the lowest possible risk and the highest possible return. This whole idea is graphically illustrated here and we are sure each one of us must have seen this graph at least once in our lifetime.
This graph depicts the idea beautifully but there is one flaw. The Risk-Return trade-off line is not a straight line in real life. That is, the return per unit of risk is not constant. More risk will not necessarily bring you more return and the return per unit of risk start diminishing as you take more and more risk. This is the second concept of Investment called Law of Diminishing Marginal Utility.
‘Utility’ is a term used in economics to describe how much value or happiness one derives from a good or service. Marginal utility refers to how much additional value/happiness is derived from one additional unit of the good or service. Most goods and services are said to have “diminishing marginal utility.”
‘Diminishing marginal utility‘ can be understood by this simple example – If you are hungry, you will relish your first dosa, you may eat your second dosa but very few of us will enjoy the third one. As our hunger satiates after the first one, our urge to eat another dosa diminishes though the taste of each dosa is the same.
More risk can’t generate a proportionate higher return and it’s a fact of life that markets fluctuate and unpredictable. But occasionally markets experience bouts of extreme volatility and declines, which can wreak havoc on portfolios. Statistics over the last 20 years show 5% pullbacks typically happen about two to three times a year, 10% to 15% corrections every one to two years and 20% bear drops every three to five years and over 50% once in a decade.
It’s easy to ride out small fluctuations given a long time horizon. But with rare large declines, most investors get perturbed by the mark to market loss and allow the behaviour aspect rode over the fundamental aspect of investment. It would be better having a bit of protection or hedge — either for peace of mind or for performance. This concept of Investment is called Hedging, which can be achieved by buying derivative to protect your long position. This cost reduces your return in an up swinging market but protect you from draw downs and generate better risk adjusted return.
Hedging risk has been an integral part of the financial markets for centuries. One of the more notable early successes came in the 17th Century when commodity producers and merchants devised a way to protect themselves against unfavorable price changes through a system of ‘forward contracts’.
Another aspect of hedging is Arbitrage. Arbitrage is a strategy where you try to capture the price difference of stock, commodity, etc in two different markets by buying in one and selling in another simultaneously. This is a market neutral strategy and you are not concern about the market direction. In India, you profit by exploiting the price differences by buying in the cash market and selling in the future market. Subsequently, you square up the trade on or before the expiry of future contract to realise the gain.
The term ‘hedge fund‘, however, dates back only to 1949. At that time, almost all investment strategies took only long positions. Alfred Winslow Jones, a reporter for Fortune, published an article arguing that investors could achieve far better returns if hedging became an integral part of an investment strategy. Jones launched a small investment partnership to test his belief. He incorporated two investment tools into his strategy – short selling and leverage – to simultaneously limit market risk and magnify returns.
As an Indian, we have historically invested in long-only strategies, be it Stocks, Mutual funds, PMS or Insurance. Since the naked short sale is not permitted in any of these investment avenues, we never benefited like global investors and fund managers who take advantage of mispricing, overvaluation, and euphoria in the markets to make investment returns by shorting a stock. This strategy yields sizable returns in bearish markets, where the share prices take a plunge.
A long-short strategy is used primarily by hedge funds, seek to deliver positive returns with low correlation to equity markets by taking long positions in stocks whose prices are expected to rise and short positions in stocks that are expected to decline.
The fund manager take a long position in a stock by buying it: If the stock price rises, the fund will make money. For shorting a stock, fund either uses the derivatives or borrows the stock they don’t own, sell it and then hoping it declines in value and then buy it back at a lower price and return the borrowed shares.
The Indian equity market is more volatile than US, European and other major Asian markets. Higher Volatility in the market couple with Lower Correlation and Higher Dispersion among Indian stocks provides an opportunity to generate alpha through active management of long and short positions.
Hedge funds profit from winners and losers both by taking long positions in winning stocks and short positions in losing stocks; it reduces the volatility and limits max draw down.
Structure of Hedge Funds in India
Hedge Funds in India are category III Alternative Investment Fund governs by SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”).
Alternative Investment Fund or AIF are privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors.
Specific exclusions include family trusts, employee stock option trusts, employee welfare trusts or gratuity trusts, holding companies, special purpose vehicles not established by fund managers and regulated under a specific regulatory framework (eg. securitization trusts), and funds managed by registered securitisation or reconstruction companies.
An AIF under the SEBI (Alternative Investment Funds) Regulations, 2012 can be established or incorporated in the form of a trust or a company or a limited liability partnership or a body corporate. Most of the AIFs registered with SEBI are in trust form.
Category I AIFs
AIFs which invest in start-up or early stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable and shall include venture capital funds, SME Funds, social venture funds, infrastructure funds and such other Alternative Investment Funds as may be specified.
“Angel fund” is a sub-category of Venture Capital Fund under Category I Alternative Investment Fund that raises funds from angel investors and invests in accordance with the provisions of AIF Regulations.
Category II AIFs
AIFs which do not fall in Category I and III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements. Various types of funds such as real estate funds, private equity funds (PE funds), funds for distressed assets, etc. are registered as Category II AIFs.
Category III AIFs
AIFs which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. Various types of funds such as hedge funds, PIPE Funds, etc. are registered as Category III AIFs.
There is no exact definition for the term “Hedge Fund”; but it is generally accepted that any investment fund that used incentive fees, short selling, and leverage are hedge funds. However, there are many category III AIF which are not utilizing the hedging and arbitrage strategies and are engage in relatively traditional, long-only strategies.
The eligibility criteria and conditions for Hedge funds in India are:
- Investors can be Indian, NRI or foreign.
- Only spouse, parents and children can be a joint investor.
- Minimum corpus should be Rs. 20 Crores for each scheme.
- Minimum investment by each investor should be Rs. 1 Crore.
- The Maximum number of investors can be 1000 for each scheme.
- Category III AIFs can be both open and close ended.
- The manager or sponsor shall have a continuing interest in the respective AIF, (a) of not less than 5% of the corpus (in Category III), or (b) Rs. 10 Crores (for each scheme) whichever is lower.
- Leverage of a Category III AIF cannot exceed 2 times the NAV of the fund.
- Units of close-ended AIFs may be listed on stock exchange, subject to a minimum tradable lot of Rs. 1 Crore and such listing of AIF is permitted only after the final close of the fund or scheme.