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Why hedge funds are attractive
Rishi Nathany in Mumbai
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November 05, 2007

There are a large number of investment vehicles that offer you good and stable returns. Products like diversified mutual funds, blue chip stocks and property are some of them. But for high net worth individuals (HNIs), there are more routes, especially in the international markets. Here we look at one such vehicle, namely hedge funds.

A hedge fund is a common term used to describe private unregistered investment partnerships. Since most of them are not registered with financial regulators in their countries of origin, they do not need to meet the eligibility requirements to register as institutional investors. This is good in a way but could turn sour as well because there are no guidelines binding them. At present, there are no hedge funds operating out of India. But internationally, there are a large number of such funds.

These funds are very manager-centric as the entire onus of their success or failure falls on the fund manager's ability to exploit existing market conditions. No wonder then that they charge a fixed fee of around 2 per cent a year of assets under management, along with a very high profit sharing percentage, which is mostly 20 per cent.

Of course, they have to assure returns as well. Thus, profit sharing may start on the returns over and above say, the first 10 per cent returns. The fee is also based on a high watermarking concept, which means that the fund manager is entitled to a share of profits the first time. Thereafter, if the fund incurs losses and then recoups, the fund manager will not be entitled to any share of the recouped losses. The next time he will be entitled is when he beats his earlier performance.

However, given the plethora of opportunities worldwide, the fund manager has the luxury of making investment decisions in stocks, bonds, commodities, currencies etc. The basic idea is to generate aggressive returns.

The most important feature of hedge funds is that they seek to deliver absolute, rather than benchmarked returns. For example, equity mutual funds are benchmarked against an index like the Nifty or BSE 200, or a banking sector mutual fund could benchmark its returns against the banking index on a stock exchange and can show the investors how much better/worse he has performed. However, hedge funds managers do not have any such luxuries.

Since they are not regulated, most countries do not allow them to raise money from the general public through a prospectus or advertisements. A few are registered with the regulators in their countries because their main investors are universities, pension funds and insurance companies.

Most of the marketing is done through investment advisors or personal contacts, with their main investors being restricted to sophisticated HNIs.  With the Reserve Bank of India [Get Quote] (RBI) allowing Indian residents to invest up to $200,000 abroad per head a year, it is another opportunity for HNIs to tap these funds as the minimum limit of many of them start from $100,000. But you need to remember that the amount invested is not very liquid and may be subject to a lock-in period, with quarterly, half-yearly or yearly exit windows.

Those seeking to invest in hedge funds can approach a wealth manager, securities broker or investment consultant abroad, who can advise them on the available options and select the hedge fund they wish to invest in, based on its track record and management style. After that they can approach their bank in India to arrange for the foreign remittance to the hedge fund. Whenever they wish to redeem their investment, as permitted by the hedge fund, they can repatriate the proceeds to India into their bank account.

The writer is director, Touchstone wealth planners.

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