Hedge Funds: Strategies For Generating Alpha In Dynamic Markets

Over the years, hedge funds have gained popularity due to their ability to generate alpha (excess returns earned on investment above the benchmark return when adjusted for risk) in dynamic markets. The key to success is having a solid investment strategy that can adapt to dynamic market conditions. In this blog, we will explore what is alpha, delve into various strategies employed by hedge funds to generate alpha returns, discuss the investment process, analyse the risks involved, and things to consider while selecting the right hedge fund. Whether you are an experienced investor or a beginner, understanding these strategies can help you make informed investment decisions and achieve higher returns.

What Are Hedge Funds?

Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 introduced Hedge Funds in India in 2012¹. They fall under Category III and constitute funds that employ diverse investment strategies and instruments targeting positive performance regardless of market conditions.

As per the regulations, only accredited investors can invest in hedge funds. The minimum size for investing in these funds is INR 1 crore per investor and an entire fund needs to have a minimum corpus of INR 20 crore². These guidelines make them ideal for high-net-worth or institutional investors. Additionally, there is risk attached to these funds which makes them suitable for aggressive investors with a high-risk appetite in pursuit of higher returns.

What Is Alpha?

Alpha in investing world means the ability of an investment strategy to beat the market. Alpha is referred to as ‘excess return’ or ‘abnormal rate of return’ concerning a benchmark or an index. Alpha measures the return above the normal expectation based on the level of risk. It is also used as a simple measure of whether an actively managed fund outperformed the index such as Nifty 50 or Sensex. A positive value means outperformance, while a negative alpha means underperformance. A positive alpha of 2.5 means the stock has beaten the index by 2.5%. 

Strategies Used By Hedge Funds

• Long/Short Equity Strategy: This is one of the most common strategies and involves taking both long positions in stocks expected to rise in value and short positions in stocks expected to decline. For example, a fund takes a long position in ICICI Bank and simultaneously takes a short position in IndusInd Bank or vice versa depending on the research and analysis of the fund manager.
• Global Macro Strategy: Global macro hedge funds analyse macroeconomic factors and make investment decisions based on their assessment of global market trends. By anticipating and capitalizing on shifts in global economic policies, interest rates, and geopolitical events, global macro funds aim to generate alpha.
• Event-Driven Strategy: Event-driven strategies focus on capitalizing on corporate events such as results, mergers, hiving off, and other significant announcements. Hedge funds employing this strategy analyse the potential impact of these events on stock prices and seek to take advantage of pricing inefficiencies that may arise.
• Relative Value Strategy: Relative value strategies involve identifying and exploiting pricing discrepancies between related securities or asset classes. Hedge funds utilizing this strategy seek to profit from price convergence or divergence. For example, funds may simultaneously buy undervalued securities and sell overvalued securities within the same sector or market, aiming to capture the price normalization that may occur over time thereby generating alpha.
• Managed Futures Strategy: Managed futures funds focus on trading futures contracts and other derivative instruments. These funds utilize systematic approaches, relying on quantitative models to identify and capitalize on trends and patterns to generate alpha. For example, funds may trade futures contracts on commodities like crude oil, gold, or agricultural products based on system-generated trend-following signals.
• Arbitrage Strategy: Arbitrage strategy involves taking advantage of price discrepancies between related securities or markets. Hedge funds employing this strategy seek to simultaneously buy shares in the stock market and sell futures, or buy in one exchange and sell in another to profit from pricing differences.

Hedge Fund Investment Process

The hedge fund investment process involves the following stages:

1. Identification of fund
2. Due diligence
3. Analysis of the strategy being followed by the fund
4. Risk assessment along with regulatory compliances
5. Portfolio construction

Investors assess a fund manager's track record, investment philosophy, and risk management capabilities before allocating capital.

Risks Involved In Hedge Fund Investing

Investing in hedge funds brings in higher returns but is commensurate with the higher risks attached to it. Some of the risks are as under:

• Strategy Risk: There is an inherited risk in the strategies involved which can put your investment at risk of huge losses.
• Liquidity Risk: Some hedge funds may invest in illiquid assets or employ strategies with limited liquidity. In times of market stress or emergencies, such positions may be difficult to exit at desired prices.
• Lock-up Period: There is a lock-up period involved while investing in hedge funds which means that your funds are blocked for some years. Any withdrawal in case of an emergency during this period will involve exorbitant penalties and charges.
• Leverage Risk: Hedge funds often use leverage, borrowing money to amplify their investment which makes them prone to huge losses in case of the market goes against the strategy.

One of the key ways to manage risk in hedge fund investments is through diversification. Another important factor in managing hedge fund risks is staying informed about the market and regulatory changes. This requires ongoing due diligence and monitoring of your investments.

Factors Influencing Hedge Fund Returns

Several factors can interact and influence the performance of hedge funds and investors should keep the same in mind before allocating capital to the selected Hedge Fund. Some of them are listed as under: 

• Fund manager’s skill and expertise
• Market conditions
• Investment strategy
• Risk management practices
• Fund size

Monitoring And Evaluating Hedge Fund Investments

Ongoing monitoring and evaluation of hedge fund investments are essential. Investors should track performance, risk metrics, investment strategy adherence, and operational aspects of the fund. Regular assessments ensure that hedge funds continue to align with investment objectives and meet expectations.

Things To Consider Before Selecting The Right Hedge Fund

1. Investment Goals: Every investor has some financial goals in his mind that he aims to fulfill. As these funds come with a lock-in period, it is more suitable for fulfilling long-term financial objectives. It is advisable to analyse your financial objectives ensuring they are in sync with the fund’s objectives before investing in them.
2. Risk Tolerance: A hedge fund comes with a high degree of risk. It has great return potential but comes with the risk of incurring significant losses. Due to this, a hedge fund is an ideal investment for aggressive large investors only.
3. Fee Structure: Understand the fund's fee structure, including management fees and performance fees. Evaluate whether the fees are reasonable given the fund's past performance and the value it provides. High fees impact your returns directly.
4. Fund Management Team: Evaluate the fund manager's experience, expertise, and reputation. Investors should assess their investment track record, investment philosophy, and their ability to execute the chosen strategy effectively. 
5. Fund Terms and Lock-up Periods: Review the fund's terms and conditions, including lock-up periods, redemption restrictions, and withdrawal policies. 

Conclusion

Hedge funds are considered to be an alternative asset class that offers higher returns compared to traditional investments. Due to the nature of these funds, they could be an ideal alternative investment for large and institutional investors. It is important to note that each strategy carries its own risks and rewards, and hedge fund managers apply their expertise and insights to navigate these dynamic markets successfully. By adopting these strategies and adapting to changing market conditions, hedge funds strive to generate alpha for their investors. But the use of such concentrated investment strategies can lead to huge losses as well. Hence, investors should do thorough market research before going ahead with any investment decisions in hedge funds.

References:

1. Securities and Exchange Board of India (SEBI) <https://www.sebi.gov.in/legal/regulations/jan-2022/securities-and-exchange-board-of-india-alternative-investment-funds-regulations-2012-last-amended-on-january-25-2022-_55672.html> 
2. Securities and Exchange Board of India (SEBI) <https://www.sebi.gov.in/sebi_data/attachdocs/1471519155273.pdf> 

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