By Shashank Tyagi
There is no exact definition to the term “Hedge Fund”. There is neither an industry-wide definition nor a universal meaning for “Hedge Fund”. Generally, hedge funds include fund of funds, private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments such as securities, non-securities and derivatives.
Hedge funds represent a large and growing industry that offers investors an opportunity to diversify and to earn competitive returns with low to moderate volatility. It can provide benefits to financial markets by contributing to market efficiency and enhancing liquidity.
The term “hedge funds” first came into use in 1949 by Albert Wilson Jones, to describe any investment fund that used incentive fees, short selling, and leverage. Over time, hedge funds began to diversify their investment portfolios to include other financial instruments and engage in a wider variety of investment strategies. However, hedge funds today may or may not utilize the hedging and arbitrage strategies that hedge funds historically employed, and many engage in relatively traditional, long-only equity strategies. They often assume risks by serving as ready counterparties to entities that wish to hedge risks. Hedge funds can also serve as an important risk management tool for investors by providing valuable portfolio diversification.
Further, some jurisdictions are slowly moving towards allowing the marketing of hedge fund and fund of funds products to retail investors. Those jurisdictions have simultaneously imposed disclosure requirements to ensure that investors understand the complexity and associated risk of investing in hedge funds. Realizing the growing importance of hedge funds, several emerging market regulators have opened their markets to offshore hedge funds by providing authorization as registered foreign investors.
In view of the increasing popularity among the institutions as well as their increasing interest in the Indian market, it might be time to provide a limited window to this growing segment of asset management industry within the existing framework of the SEBI (Alternative Investment Funds) Regulations 2012, subject to the Reserve Bank of India.
Meaning & Definition of Hedge Fund
“A hedge fund is an investment structure for managing a private, loosely regulated investment pool that can invest in both cash (physical securities) and derivative markets on a leveraged basis.”
“Hedge fund — An absolute return investment fund designed to invest in a wide range of instruments in order to achieve a high return for a given level of risk. It is usually based offshore and the manager is reimbursed through an incentive fee.”
“Hedge funds are considered ‘alternative’ investment since they employ an investment strategy that differs from conventional, long-only, money management. It encompasses a greater variety of investment instruments (options and futures) and a greater variety of investment techniques (short selling, hedging, arbitrage etc.) than conventional money management.”
“Hedge funds — usually structured as private placements — encompass a wide variety of skill-based investment strategies such as fixed income arbitrage, risk arbitrage, hedged equity, directional equity, convertible bond arbitrage, event-driven, global macro, and emerging markets. While most hedge funds primarily invest in the debt and equities markets, some may also take significant positions in the currency and commodities markets. Common to most hedge funds is the use of leverage and both long and short positions. Because hedge funds are able to take short positions, they have the potential to profit in any market, including one characterized by sharply declining market.”
According to US Securities & Exchange Commission
“Hedge fund” is a general, non-legal term used to describe private, unregistered investment pools that have traditionally been limited to sophisticated, wealthy investors. Hedge funds are not mutual funds and, as such, are not subject to the numerous regulations that apply to mutual funds for the protection of investors — including regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, regulations limiting the use of leverage, and more.
According to Andersen — European Definition
European market professionals consider that a hedge fund is any fund which adopts an alternative investment strategy seeking to generate high absolute rate of returns. Any collective investment scheme employing asset management strategies which can benefit from rising as well as declining market price could be qualified as a hedge fund. Unlike the US, there are many hedge funds which do not involve a relationship with a prime broker, but which are considered “hedge funds” as a result of the trading strategies adopted and the financial strategies dealt with by the fund.
In India
According to SEBI (Alternative Investment Funds) Regulations, 2012, Regulation 2(1)(l): “Hedge fund” means an Alternative Investment Fund which employs diverse or complex trading strategies and invests and trades in securities having diverse risks or complex products including listed and unlisted derivatives.
History & Progression of Hedge Fund
The first hedge fund was established on 1 January 1949 by Alfred Wilson Jones. He was a sociologist and financial journalist and was born in Melbourne (Australia). He is also called the father of hedge fund. In 1952, Jones opened up his partnership to other managers and started to hand over to them the management of portions of the portfolio. Within a short period of time he assigned them the task of picking stocks. Jones would allocate the capital among his managers, monitor and supervise all investment activities and manage the company’s operations. At that time, the first hedge fund in history turned into the first multi-manager fund in history.
Further, in 1967, Michael Steinhardt started Steinhardt, Fine, Berkowitz & Company with eight employees and an initial capitalization of only $7.7 million. Steinhardt began his career as a stock picker and then, as his hedge fund grew, shifted to a multi-strategy fund. By 1969, the US Securities and Exchange Commission had started to keep a watchful eye over the blossoming industry of hedge funds as a result of the rapid growth in the number of new hedge funds and of assets under management. At that time, the commission estimated that approximately 200 hedge funds were in existence, with $1.5 billion of assets under management.
George Soros also created the Double Eagle hedge fund in 1969.
Further, in 1969 the first fund of hedge funds was also created in Geneva by Georges Karlweis of Banque Privée Edmond de Rothschild, which was named “Leveraged Capital Holdings”. The purpose of this fund of funds was to invest in the best single managers of the time. It also represented the first European hedge product. In 1971, the first US fund of funds was started by Grosvenor Partners and in 1973, the Permal Group launched the European multi-manager and multi-strategy fund of funds, which is called Haussmann Holdings N.V.
Then in 1980, Julian Robertson and Thorpe McKenzie created Tiger Management Corporation and launched the hedge fund Tiger with an initial capital of $8.8 million. In 1983, Gilbert de Botton started Global Asset Management (GAM), a company specializing in the management of funds of hedge funds, which in 1999 was acquired by UBS AG and by the end of 2004 had some 38 billion euro of assets under management (AuM). The main impulse for the growth of the fund industry came with the success of Julian Robertson’s Tiger fund.
In 2004, the SEC (Securities and Exchange Commission) adopted changes that require hedge fund managers and sponsors to register as investment advisers under the Investment Advisers Act 1940. The main motive behind these changes was to protect the investor’s rights. It made some great changes in the hedge funds industry such as (i) increased the number of requirements placed on hedge funds, (ii) including keeping up-to-date performance records, (iii) hiring a compliance officer and creating a code of ethics.
In 2008, in the hedge fund industry many of the best and brightest managers and investors faced some losses due to the reason of the Global financial crisis. The year 2008 was one of the worst years in the history of financial markets. In the first half of 2009, after facing financial crisis for a long period of time, the industry as a whole bounced back in dramatic fashion and saw its popularity rise among many investors.
In India scenario
In India, this is a new phenomenon. Even after making so many efforts, the researcher did not get any blueprint of hedge funds since 1990. In 1991, while the Government adopted liberalizing policy in the industrial sector with intention to boost up the country’s economy and industrial sectors, the concept of hedge fund got a chance to introduce itself in India as a form of FII (Foreign Institutional Investors). It happened because Government of India opened the door for the foreign investors into the security market. Moreover, due to the boon of globalization the business has expanded worldwide.
After this golden period the SEBI (Securities & Exchange Board of India) came into existence on 4 April 1992 and passed the notification of SEBI (Mutual Fund) Regulation 1993 for investing the hedge funds in securities markets and made some rules governing portfolio managers who pursuant to a contract or arrangement with clients. We have, however, no information about any hedge funds domiciled in India.
Further, on account of limited convertibility, offshore hedge funds have yet to offer their products to Indian investors within India. At that time some hedge funds had invested in offshore derivative instruments issued by FIIs against underlying Indian securities. Through this route hedge funds can obtain economic benefit of investing in Indian securities without directly entering the Indian market.
To manage these funds in Indian markets, recently the Securities Exchange Board of India has introduced SEBI (Alternative Investment Funds) Regulations, 2012. The main objective of these regulations is to bring all funds established or to be established in India under one omnibus statutory regime. Further, on 21 January 2013 the SEBI introduced Securities & Exchange Board of India (Investment Advisers) Regulations, 2013. The regulations seek to regulate the activity of investment advice.
Characteristics of Hedge Fund
Flexibility — Hedge funds are flexible in nature. In this concept the managers can invest or trade in any financial instruments such as derivative, leverage, short-selling etc. They can invest in these instruments for short and long periods of time. The main motives of hedge fund managers in investing in these instruments are to reduce risk, enhance return and minimize the correlation with traditional investment models like equity and bond markets.
Skill-Based Strategies — Most hedge funds are managed by experienced investment professionals, who have sufficient knowledge of markets, crucial strategies, and the key skills to handle risks. Those investment professionals are called hedge fund managers.
There are some regulations also passed by SEBI for hedge managers for advising investors in the light of SEBI (Alternative Investment Funds) Regulations, 2012 & SEBI (Investment Advisers) Regulations, 2013 in India. Further, Investment Advisers Act, 1940 of US also gave some regulation for hedge fund managers. The sole motives of these regulations and the Act are to protect investors and maintain transparency.
On the other hand, in this fund only limited numbers of investors can invest or you can say that it is a pool of funds of highly influential investors. It also includes large numbers of expertise-based investment strategies like global macro, event-driven, directional and relative value etc.
One unique feature of hedge funds is the absolute returns given by the hedge fund’s managers to investors. Although hedge funds have risks like market risks, economic risks, currency risks and commodity risks, the managers play a crucial role to manage these funds. In this concept of investment the managers always make a promise to give returns before the investors and they charge a higher performance fee to manage and mitigate these risks. The hedge funds can trade in both cash markets and derivative markets.