Hedge Fund - Definition, Types, Strategies, Due-Diligence, and Risks.

What is Hedge Fund? and How does a hedge fund work?

It is a type of investment vehicle that pools capital From High-Net-Worth Investors or Qualified investors and invest in different securities on their behalf.

➤  The word Hedging is actually the practice of attempting to reduce risk. but now days it isn't accurate to say that hedge fund just hedge risk or reduce risk.  

➤  High-Net-Worth investor or Qualified investor :-  it can be a person (High net-worth individual, HNI) or an Entity. 

• Individuals(HNIs) having Annual income $200,000 for the past two years or a net-worth exceeding $1million, excluding their Primary residence (In India, you require a minimum investment amount of Rs.1 crore) to invest in a hedge fund.

• Entities, they must have minimum of $500,000 in total assets to invest in hedge fund. (e.g. of entities :- Pension fund, Endowment fund, Banks and Insurance companies).

➤ The Hedge Fund is operated by a Fund manager (General Partner) who invests the money into different securities, such as Land, Real Estate, Currency, Equity, Bond, Derivative etc. In-short anything but according to its mandate. 

➤ Performance of a hedge fund is fully depends on the ability and decision of  Fund manager.

➤ Hedge funds are less regulated than Mutual funds or ETFs.

➤  Hedge Funds are versatile investment vehicles that can use Derivatives, Leverage, and take short positions in stocks.

Why are Hedge Fund consider to be Illiquid?

➤ Hedge Fund Investors can not simply withdraw their money whenever they want it is known as Lock-Out Period and they can only withdraw the funds at specified times with advance notice.

➤ Also hedge fund invest in illiquid securities, so a advance notice period is required otherwise liquidation will cause Impact cost.

What are the Strategies of Hedge Funds?

Hedge Fund Classification is difficult because of diverse strategies and uniqueness. 

These are some Popular Hedge Fund Classification :-

➧ Equity Oriented:- 

• Market Neutral:- Go long on a stock which is relatively under price and short on a stock which is relatively over price, such that Beta equals to ZERO. 

• Fundamental Growth:- Buy stocks of growth oriented companies which as per your fundamental analysis, have strong future prospect.

• Fundamental Value:- Buy stocks of those companies which are Beaten by market but, as per your fundamental analysis have strong future prospect.

• Quantitative Directional:- Based on technical analysis, take long-short position in relatively misprice securities. 

➧ Event Driven:-

• Merger-Arbitrage:- Take a long position in the target company and the short position in acquiring company.

• Distressed Security investment:- Take a long position in the equity or debt of a company who is in Financial Distressed and hope for a turnaround and resultant value creation.

•  Activist Shareholder Investing:- Take a Significant Stake in a company and actively participate to create value in the company.

• Special Situation:- Take long or short position in companies undergoing massive Reorganization like- Equity issue, Buyback etc.   

➧ Relative Value:- 

• Convertible Fixed income Arbitrage:- The hedge fund identifies an underprice convertible bond and buys the same, Obviously this gives the hedge fund an imbedded call option (C+), in order to hedge itself hedge fund short sell delta shares. so over all the hedge fund having Plain Bond [C+ & △S⁻].

• ABS Fixed Income:- The Hedge fund goes long in one Trench ( Senior, Mezzanine, or Junior) and short in another, which according to the fund are relatively mispriced.

• Regular Fixed Income:- Buy an underprice bond & sell an overprice bond.

➧ Global Micro:-

• Based on global trends the hedge fund manager takes long short position in equities, fixed income, commodities & currency.

Hedge Fund Performance:-

• Hedge Fund underperform traditional investment in rising equity markets but outperform traditional investment in falling market.

• Actually there are so many hedge fund strategies that it is difficult to make a general comment. some may outperform during some time and others during other time.

• Of course the rational of low correlation of hedge fund does speak of diversification of benefit. However investors need to aware that correlation Spikes during Crisis.( means the benefits of diversification is not available exactly at the time when they are needed).

Hedge Fund Due-Diligence:-

• On account of lack of transparency, lack of credible historical data, Subjective valuation practice etc. due-diligence is extremely difficult.  the factor that are taken into consideration while carrying out due diligence are:-

• Fee Structure.
• Risk Management Strategy.
• Benchmarking.
• Manager Turnover.
• Manager Lifestyle.
• Return objective:- Absolute & Relative.

NOTE:- 

• Fund manager's performance is not persistent, which means past winners may be future looser. hence, due diligence become more difficult.

Thank You, Stay Happy and Safe....