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B. Venkatesh

YOU may have read reports recently about SEBI regulating hedge fund investment in India. What are hedge funds?

A hedge fund differs from a regular mutual fund in its investment strategies. Such funds typically generate returns through security selection.

Suppose a fund has only HDFC in its portfolio. Assume that the stock generates 15 per cent return in six months against the market index return of 10 per cent. The return specific to investing in HDFC is, therefore, 5 per cent.

A hedge fund would build its portfolio such that it generates only 5 per cent return, while a regular mutual fund would generate 15 per cent. Of course, that is only side of the equation.

Because hedge funds aim for stock-specific returns, they run a lower market risk. Suppose the market declines 20 per cent but HDFC falls by only 7 per cent. The hedge fund will approximately lose 7 per cent, whereas a regular mutual fund will lose 20 per cent.

Hedge funds neutralise or at least reduce market risk by primarily investing in derivatives. In the above case, the hedge fund would take short position in index futures to protect against the decline in the market index.

Another important characteristic is that hedge funds borrow heavily to increase their portfolio size.

Assume a hedge fund collects Rs 1,000 crore from investors. It may borrow, say, Rs 2,000 crore and invest Rs 3,000 crore in stocks and bonds. Many perceive hedge funds as risky because of this leverage factor.

Finally, hedge funds construct a concentrated portfolio. A typical mutual fund will invest in many stocks to reduce risk.

This is called portfolio diversification. A hedge fund, however, invests in few stocks because it aims at generating security-specific returns. Hedge funds primarily cater to high net worth individuals.

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