What Are Hedge Funds? Meaning, Strategy & How They Work

In the world of investments, hedge funds are exclusive, high return vehicles catered to sophisticated investors. Hedge funds are able to generate profits regardless of the market due to aggressive trading, professional management, and advanced risk control.

This blog explains what a hedge fund is, how it works, the main tactics it employs, and provides a list of some of the top hedge funds in India.

 

What Is Hedge Funds? (Hedge Fund Meaning)

 A hedge fund is a privately operated and managed investment fund that gathers capital by way of high net worth individuals or institutional investors then invests it in a wide variety of assets such as stocks, derivatives, currencies and even commodities.

There is no similarity between hedge funds and mutual funds because hedge funds seek absolute return strategies which implies trying to make money regardless of the market conditions.

At the most basic level, a hedge fund is simply an investment fund that hedges and can hedge its risks using long/short positions, trading in derivatives and leveraging.

 

Example:

 A hedge fund manager will buy (go long on) stock A and short (sell) stock B if they believe the value of stock A will rise and stock B will fall. In this manner, they will continue to profit from changes in the market in either direction.

 

 

How Hedge Funds Work

Unlike traditional funds, hedge funds adopt a flexible and activistic approach when it comes to fund management. This is how they work:

 

1. 1. Fund Structure: Hedge funds are set up as private limited partnerships. Investors act as limited partners (LPs), while fund managers take on the role of general partners (GPs).

2. Capital pooling: Approved investors must make a minimum investment of Rs. 1 crore. Most of these investors are high-net-worth individuals (HNWIs) in India.

3. Investment Strategies: Diversified strategies are used with the pooled capital with the goal of a desirable balance between risk and return.

4. a) Management Fee: Typically, 1 to 2 % of total assets under management (AUM).

b) Performance Fee: 20 % of the profits made.

5. Leverage and Derivatives: Hedge funds use borrowed money and/or derivatives to increase risk and potential returns and risks.

Key Characteristics of Hedge Funds

 

Feature	Description
Investor Type	Accredited or High-Net-Worth Investors
Regulator (India)	SEBI (Category III AIF - Alternative Investment Fund)
Liquidity	Limited - Investors must stay locked in for months or years
Objective	Generate absolute returns across all market conditions
Transparency	Less regulated and more flexible than mutual funds
Risk Level	Higher, due to leverage and complex strategies

Hedge Fund Strategies Explained

 Hedge funds are well known for using a variety of investment strategies. The following is a list of some of the most widely used and successful investing strategies:

 

1. Long/Short Equity Strategy

 This is the most classic hedge fund approach. The fund sells stocks that are predicted to decline (short) and purchases stocks that are anticipated to rise (long).

 Example: Long on Infosys, Short on TCS - if the spread widens in favour of Infosys, the fund profits.

 

2. Market Neutral Strategy

 The goal is to eliminate overall market risk. Funds balance long and short positions to the extent that the gains and losses from market movements cancel each other out, thereby focusing on stock-specific performance.

 

3. Global Macro Strategy

 These funds make investments based on general macroeconomic patterns such as changes in GDP growth, interest rates, inflation and currency volatility.

Example: Betting on the U.S. dollar to increase or fall in oil prices.

 

4. Event-Driven Strategy

 This strategy focuses on profiting from corporate events such as mergers, acquisitions, or bankruptcies.

Example: Buying a company’s stock before a merger announcement that is expected to push the stock price higher.

 

5. Arbitrage Strategy

 

This strategy is based on mismatches in prices of related securities. An arbitrageur buys a security in one market and sells it in another for a guaranteed profit with little risk.

Each of the strategies above assists in the diversification of hedge funds and helps avoid sudden market swings. This improves hedge fund returns.

 

Hedge Funds Vs Mutual Funds

 

Basis	Hedge Funds	Mutual Funds
Investor Type	HNIs and Institutions	Retail and Institutional Investors
Regulation	Light (AIF Category III)	Highly Regulated (SEBI)
Risk Level	High	Moderate
Leverage	Allowed	Not Allowed
Return Objective	Absolute Returns	Benchmark Returns
Liquidity	Low (Lock-in period)	High (Redeem anytime)

 

Hedge Fund Returns: How Profitable Are They?

Hedge fund returns hinge on the type of strategy a fund employs, the risk a fund manager is willing to take, and the prevailing market conditions. In India, during the earlier years, top hedge funds' annualised returns ranged between 12%-18%, while in bullish cycles, hedge funds globally managed to achieve returns of over 20%.

However, hedge funds can see a steep decline in their returns during volatile and bearish markets, especially if the strategies being implemented are not adaptable. Top hedge funds are focused on risk-adjusted returns. This refers to the strategy of providing consistent, stable returns, while not exposing investors to significant market risk.

 

Best Hedge Funds in India

Compared to the U.S., hedge funds are a relatively recent concept in India. Nonetheless, a number of SEBI-registered Category III AIFs are demonstrating consistent performance.

 

Hedge Fund Name	Type / Strategy	Approx. Returns (Annualized)
Avendus Absolute Return Fund	Long/Short Equity	13–15%
ASK Pravi Hedge Fund	Equity Long/Short	12–14%
Edelweiss Alternative Equity Scheme	Market Neutral	10–12%
ICICI Prudential AIF Fund	Multi-Strategy	11–13%
Alchemy Alternate Fund	High-Conviction Equity	15%+

 

(Note: Returns are indicative based on historical data and not guaranteed.) 

These are among the best hedge funds in India as they professionally manage funds and gauge the performance of several sophisticated strategies to provide hedge fund returns that outperform traditional investments over time.  

Benefits of Hedge Funds  

• Hedge Fund Diversification: Hedge funds can invest and analyse multiple strategies which improves performance across several asset classes as well as markets.  

• Higher Return Potential: Hedge Funds use leverage which tends to optimise profits and outperform the market as compared to traditional investments.  

• Hedge Fund Active Portfolio Management and Absolute Return Focus: Fund managers are tasked with the job of actively managing and optimising the performance of the funds and ensuring capital growth performance in stark bullish and bearish markets during the investment period.  

 

Risks Associated with Hedge Funds

• Hedge Fund High Minimum Investment: Hedge funds generally require investments over Rs. 1 crore which can be a steep barrier to entry.  

• Hedge Fund Fund Lock in Restrictions: Most hedge funds implement their strategies in over 1-3 year time frames, meaning capital can be locked in for that period.  

• Complex Investment Strategies and High Hedge Fund Fees: Most hedge funds employ a profit and fee structure of "2 and 20" meaning they will take 2% of the capital for managing and 20% of all profits generated thus imposing complex profit structures.  

These risks mean hedge funds are best for seasoned investors with a high tolerance for risk. 

 

 

Conclusion

 Hedge funds are important players in the modern financial marketplace because they provide the opportunity for high returns, diversification, and professional management. They are different from mutual funds with respect to the risk, structure, and investment strategies, making them more appropriate for sophisticated investors.  

If you are interested in what hedge funds are, how they generate hedge fund returns, or want to find the best hedge funds in India, keep in mind that while hedge funds have the potential to provide market-beating returns, they also require a considerable amount of time, research, and professional guidance to invest in them.  

DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.