The world of finance thrives on complexity, and few corners embody this more than the realm of hedge funds.
The Indian hedge fund industry, up until now, was accessible only via AIFs (Alternative Investment Fund) and, due to their high minimum threshold, was confined to investors with deeper pockets. That is set to change.
With the regulator having relaxed the norms, a much larger base of investors can now access these strategies. An altogether new category of funds has been created—SIFs (Specialized Investment Fund)—with a much lower threshold. Two asset management companies (AMCs) have already launched their schemes, and many more are in the process.
Investing in these funds, however, either through AIFs or SIFs, requires a thorough understanding of their complex risk-return trade-offs. They employ strategies that make them fundamentally different from conventional equity and debt funds. Having said that, these funds can add an important dimension to an investment portfolio, especially in a changing world order where financial market volatility is expected to increase.
This detailed article aims to provide a clearer understanding of these funds, the complex strategies they employ, and the jargon that is part and parcel.
(A) Breaking Down the Jargon
The word ‘hedge’ comes from the Old English word ‘hecg’, meaning a fence or barrier. In finance, to hedge is to take actions to reduce potential losses, much like a hedge protects a garden from unwanted elements.
Hedge funds are named for their original purpose: to hedge, or protect, investments from market risk by using both long and short* positions to offset potential losses. While modern hedge funds employ a broader range of strategies and can be very risky, the name reflects this core concept of risk mitigation and protection through simultaneous betting on both rising and falling market prices.
The first hedge fund was founded by Alfred Winslow Jones in the mid-20th century. His strategy involved taking both long (betting on price increases) and short (betting on price decreases) positions in stocks to ‘hedge’ against overall market downturns. By going long on undervalued companies and short on overvalued ones, Jones aimed to insulate the fund from market volatility while still capturing profits from individual stock picks. This dual approach was key to the ‘hedging’ in the fund’s name.
Over time, the hedge fund industry has evolved beyond simple hedging strategies. Today, hedge funds employ a variety of complex, and often highly risky, investment strategies, including leveraging capital and trading across different asset classes.
Despite the expansion of strategies, the term ‘hedge fund’ remains, still implying the potential for risk management, although the level of actual hedging can vary significantly between funds.
This also brings us to the other meaning of the word ‘hedge’—which is to avoid giving a direct answer. The risk-reward equation of these strategies is not as straightforward as investing in stocks or bonds. A simple yes/no answer is often difficult and not warranted.
#Long, in financial market parlance, means buying an asset—a stock, a currency, a commodity. You stand to gain if the price goes up. Short, in market parlance, means selling an asset you do not own. You gain if the price falls.
(B) Demystifying Long-Short Strategies
At the heart of most hedge funds lie the two words long & short. Unlike traditional mutual funds that simply buy and hold, long-short funds engage in both going long on assets they believe will rise in value and going short on those anticipated to fall. This creates a fascinating dynamic.
Many investors have heard of or invested in arbitrage funds as a means of temporarily deploying short-term surpluses. They are, in general, considered safe. The fund takes a simultaneous long position on the stock of Company A (say 100 million) and a short position on the futures of Company A (for the same amount). Since most times, the futures* of an underlying stock trade at a premium to the stock, the fund pockets the difference, irrespective of which way the price moves. Arbitrage funds are among the closest examples of a practical hedge since the fund has gone both long & short on the same company, for the same amount. (1)
Now, let us start to complicate the equation.
Imagine a fund that is investing INR 100 million in Company A, expecting its value to rise, and simultaneously taking a short position of INR 100 million in its competitor, Company B, anticipating its value to fall. The fund manager is betting that Company A will do better than Company B in terms of stock performance. (2)
- Best case scenario: Company A stock goes up and Company B stock goes down. The fund makes money on both positions.
- Good case: Company A stock goes up more than Company B stock OR Company A stock falls less than Company B. The fund gains the differential.
- Bad case: Company A stock goes up less than Company B OR Company A falls more than Company B. The fund loses the differential.
- Worst Case: Company B stock goes up and Company A goes down. The fund loses money on both positions.
These kinds of trades are usually bucketed under market-neutral strategies, specifically known as pair trades. Here, the fund identifies two securities whose prices should theoretically move in lockstep but have temporarily deviated. By taking a long position in the undervalued security and a short position in the overvalued one, the fund capitalizes on this mispricing.
Complicating it further – The above example looked at two correlated stocks. What if the fund goes long on a Banking stock and short on an uncorrelated Tech stock? The fund manager is making a deliberate call that the long position is expected to go up and the short position is expected to go down.
This logic can also be applied to asset classes. If you expect equity markets to do poorly and Gold to do well, you could short an equity index (say Nifty-50) and go long on Gold. (3)
Such trades are no longer market neutral, as the prices are not anticipated to move in tandem.
Now, imagine a fund with a total corpus of INR 1000 crores. It is bullish on Gold and bearish on Nifty-50. It could decide to buy INR 500 crore worth of Gold and use the remaining INR 500 crore to short Nifty-50. In this case, the fund is only using the resources it has.
What if it extends itself? That is, it borrows—using leverage. It could then go long on Gold for INR 1000 cr and short Nifty-50 for an equal amount. (4)
*Futures are contracts that obligate the buyer to purchase an asset (or the seller to sell an asset) at a predetermined future date and price, requiring only a fraction of the total value (margin) to be paid upfront.
**Leverage brings a whole new dimension to the risk-reward equation. If the decision goes in the fund manager’s favour, the returns are magnified. If it goes against, it can lead to the closure of the fund and significant investor losses. In the world of hedge funds, it wouldn’t be wrong to say that over-extending, or leverage, is what defines them.
(C) Understanding Net Exposure vs. Gross Exposure
The distinction between net and gross exposure is crucial. Gross exposure is the sum of all long and short positions. Net exposure is the difference between the long and short positions.
Generally (but not necessarily – please see the table above), a low net exposure means the fund is less affected by overall market changes, minimizing directional risk. A high net exposure makes the fund more sensitive to market movements, amplifying both gains and losses. The gross exposure, on the other hand, tells you how much leverage the manager is employing or if the manager is over-extending the fund’s resources.
In simpler terms, long-short hedge funds aim to balance their bets, and the difference between these positions (net exposure) determines their vulnerability to market fluctuations.
[Image: Table showing examples of Net and Gross Exposure calculations]
The Net position in all the above cases is Zero. However, the implications are very different. Likewise, the gross position in the arbitrage example (1) is the same as in the leveraged example (4).
However, the big difference is that the fund manager is shorting the futures of the same stock and it is a near-perfect hedge*, whereas in (4) if the asset class where the fund has gone long falls by say 50% and the asset class where the fund has gone short, goes up by 50% – the fund will lose all its capital. For example, if the total corpus (total of client money) is INR 100, and fund takes a long position on Asset Class A for INR 100 and short position of
- Asset Class B for INR 100:
- Long position – 100 x minus 50% = Loss of INR 50
- Short position – 100 x minus 50% = Loss of INR 50
- Net Result – even though net position is Nil; the total corpus is wiped out.
There have been several such instances in global history. Long Term Capital Management (LTCM) is often quoted as its collapse nearly caused a global financial meltdown. (www.investopedia.com/terms/l/longtermcapital.asp.)
More recently, in January’24 Singapore-based Asia Genesis Asset Management** liquidated its hedge fund after a ‘significant and unprecedented drawdown’ following missteps in Chinese and Japanese bets.
The fund, which hedge fund veteran Chua launched in 2020, was managing about $300
million. The closure came amid an unprecedented stock rout in China and sustained rally in Japan. As per Reuters, the letter mentioned that they made big mistakes in the sharp Nikkei and Hong Kong moves which went in opposite directions and that he has reached the stage whereby his confidence as a trader is lost.
The fund increased long positions in Hong Kong and China and was short in Japan, based on the prediction that China would outperform Japan in 2024 after being sold off for the past three years, whereas Japan would be muted after a 30% rally in 2023. Interestingly (and sadly for the fund) had this trade been done in 2025 beginning, while Japanese markets continue to do well, Chinese markets have also had a good rally. So, the fund would have lost money on their short position in Japanese markets but made money on China. IN 2024, they lost money on both trades.
As is evident, the long-short strategies used by hedge funds, operate on an entire
spectrum. While at one end, there are arbitrage funds (which are not even referred to as
hedge funds), at the other end there are funds which employ leverage. And the leverage is not restricted to two times as mentioned in the example above. It can be lot higher. Things get complicated when funds use Options as a strategy. Options is another instrument (besides futures – though they are even more complex) which allows an investor to bet on markets with limited capital of their own.
And hence, it is very crucial to understand the personality of Gross & Net Exposures, while evaluating long-short strategies. As two funds with the same gross exposures or net exposures can have very different risk-reward profiles. Understanding the Risk and Reward matches your personality.
Also important is to understand the DNA of the Institution involved, especially with respect to its risk management policies. Undoubtedly hedge funds are helmed by some of the sharpest minds in the world of investments. This strength is also their biggest weakness and hence it is important to assess their temperament (EQ) as managing risks and yet generating good returns makes their job challenging & stressful.
*It is important to mention that there is no perfect hedge, though the history of arbitrage funds in India suggests that the risk is with respect to variability in returns and not on the capital.
**The Asia Genesis Macro Fund lost 18.8% in the first weeks of January, Chief Investment Officer Chua Soon Hock said in a letter to investors (as reported by Reuters). He decided to close the fund to prevent further loss and return money.
(D) Other Strategies Used by Hedge Funds
While long-short strategies lie at the heart of many hedge funds, there are several other distinct approaches. Another key aspect is the fund management style:
Quantitative vs Discretionary
A Quantitative fund relies on systematic, data-driven methods, such as mathematical models and AI, to make investment decisions. A Discretionary fund relies on human skill and acumen. Over time, some discretionary styles can be codified into systematic programs, as seen with Ray Dalio’s Bridgewater Associates.
Following are some of the prominent strategies used by hedge funds:
Event-Driven Strategies: Capitalizing on corporate events such as mergers, acquisitions, and buybacks. These strategies are also known as special situations. Usually these strategies form part of many hedge funds as a sub-strategy, and not the primary strategy
Option Strategies: Involve active trading in options, employing strategies like spreads and volatility trading. The complexity of options (with jargon like Delta, Gamma, Theta) means that hedge funds employing Options strategies are like a black box to most investors, which can deter clear-headed individuals from investing.
Global Macro Funds: These involve investing based on macroeconomic trends, such as interest rates or currency fluctuations. funds can take both long & short positions. An oft-quoted example of a global macro fund is George Soros’s Quantum Fund, particularly for his 1992 trade that ‘broke the Bank of England’ by betting against the British Pound. They initiated a massive ‘short’ betting on a significant devaluation of the Pound.
Absolute Return Funds
These funds aim to generate a profit in any market condition by using strategies like long & short and options trading, rather than trying to beat a market benchmark.
The absolute return funds are very popular in India and command a large share of investor wallet. They are often pitched as an alternative to debt funds. However, their track records have not been entirely consistent. A prominent fund, after a stellar run, went through a bad patch and decided to stop operations.
These funds rely significantly on options trading, a market that has seen major regulatory interventions. This could be one reason for their inconsistent performance. Given this reliance, it is very difficult for most investors to grasp the nuances, which gives these funds the characteristic of a black box.
Unlike absolute return funds, the traditional hedge funds rely more on their ability to identify undervalued and overvalued stocks, sectors, asset classes, a concept that can be easier to comprehend, though consistently executing this is challenging and burnout among fund managers can be high.
It is important to remember that not all hedge funds are created equal. While investors must be mindful of what they are signing up for, the Indian market regulator has been quite mindful of the risks, which is why access was kept restricted to high-threshold AIFs until the recent introduction of tightly controlled SIFs.
(E) Specialized Investment Funds (SIF)
These are like traditional mutual funds with a twist. An interesting one, which makes them special.
Traditional mutual funds:
- buy a stock or a bond or a commodity (gold/silver) or real estate units (REITs), with the expectation that what they have bought will go up in value. And at some stage, they sell what they have bought.
- Only deploy the funds provided to them by investors. They cannot use leverage. They do not short or use any kind of derivatives, except for arbitrage strategies
- Their gross & net exposure will be the same and will be equal to the corpus of the fund.
- Need a minimum of INR 5,000
Specialized Investment Funds (SIFs):
- Besides buying a stock or a bond or a commodity (gold/silver) or real estate units (REITs), can also short any of them, up to 25% of funds corpus.
- Only deploy the funds provided to them by investors. Same as traditional. They cannot use leverage. However, they can short and can use derivatives, up to 25% of the fund’s corpus.
- Their gross exposure cannot exceed 100% – hence equal to the corpus of the fund. However, their net exposure can be as low as 50%. Not lower. Assume a SIF has a corpus of 1000 crores. The fund has gone Long for an amount of 750 cr (it can go up to 1000 cr). The fund is allowed to go Short for up to 250 cr (25% of corpus). Hence the net corpus is 500 cr (750 – 250) or 50%. It cannot be below this number.
- Need a minimum of INR 10 lacs.
Is this a big deal?
Compared to AIFs, it is not in terms of strategy flexibility. AIFs are allowed gross exposure up to 200% and can short up to 200%, compared to SIFs at 100% and 25%, respectively.
However, unlike AIFs, the tax structure applicable to SIFs is the same as traditional mutual funds. And that is a big deal for 2 reasons:
- SIFs are subject to capital gains tax, which is significantly lower than the highest rate applicable to most AIFs.
- Investors pay tax only when they exit the SIF, not when the fund churns its portfolio. This prevents “tax leakage” and allows funds to compound on a larger base, a fundamental advantage that is accentuated in strategies that could see high portfolio churn.
(F) To Hedge or Not to Hedge?
Should one invest in hedge funds? Investors with larger sums have the option to invest in both AIFs (min 1 cr) and SIFs (min 10 lacs). Those with lesser sums can invest in SIFs. There is indeed a case to consider it. The world is going through an unprecedented phase of geo-political shifts, high debt, and market volatility. Hedge funds offer a very different risk-reward profile compared to traditional assets, and a certain allocation can reduce the volatility of an overall portfolio.
However, this should only be considered after the risks and strategies are thoroughly understood. While that is true for any investment, it is truer for hedge funds. Given that no two hedge funds are the same, the jargon is complex, and the Indian wealth management industry continues to be dominated by a sales-led culture, investors should be cautious. We believe the incentive structures of much of the industry are not always aligned with the investor, which can lead to poor decisions.
Please note that the above note is for general guidance. For specific clarity and details, we recommend reaching out for a detailed discussion before any formal moves are made. As part of a robust process, it is crucial that theories and concepts are properly vetted from the perspective of an investor’s suitability and appropriateness before any investment decision is made.
