Understanding Hedge Funds: How They Work and Types
9 June, 2025
Synopsis
Hedge funds are lightly regulated investment vehicles for accredited investors that use advanced strategies like hedging, short selling, and arbitrage to generate returns.
Hedge funds in India operate as Category III AIFs and are gaining traction among ultra-HNIs seeking differentiated, alpha-generating investments.
Given their complexity, hedge funds are best suited for sophisticated investors with a long-term view and high-risk appetite.
A hedge fund is a pooled investment vehicle that uses a wide range of strategies to generate returns for its investors. These include hedging, leveraging, short selling, arbitrage and more. Unlike mutual funds, hedge funds are typically open only to accredited investors and high-net-worth individuals. They are lightly regulated, giving managers greater flexibility in choosing investment instruments and strategies.
Hedge Fund Meaning
The hedge fund meaning goes beyond just an investment vehicle. Hedge funds aim to deliver "absolute returns"—profits in both rising and falling markets. They do this by employing diverse hedge fund strategies, such as long/short positions, derivatives, and global macro bets.
How Do Hedge Funds Work?
A hedge fund manager raises capital from a pool of investors and then applies a range of trading strategies aimed at generating alpha. These strategies can be complex and may involve leverage, derivatives or short selling. The returns are shared with investors based on performance, typically following a “2 and 20” fee structure—2% as a management fee and 20% of the profits. Hedge funds usually come with higher risk tolerance, minimum investment thresholds and lock-in periods that restrict investor withdrawals for a set duration.
Categories of Hedge Funds
Hedge funds can be categorised based on their strategy, structure or geography:
Equity Hedge Funds: Take long and short positions in equities.
Event-Driven Funds: Profit from corporate events like mergers or bankruptcies.
Macro Funds: Invest based on macroeconomic trends (currencies, interest rates).
Relative Value Funds: Exploit pricing inefficiencies between related instruments.
Quant Funds: Use algorithms and statistical models to trade.
Popular Strategies Used for Hedge Funds
Hedge funds use both conventional and contrarian strategies to beat the market. Here are some commonly used ones:
Long/Short Equity: Going long on undervalued stocks and shorting overvalued ones.
Global Macro: Betting on economic changes across countries.
Distressed Securities: Investing in debt or equity of companies undergoing financial hardship.
Merger Arbitrage: Profiting from price gaps in mergers and acquisitions.
Hedging: Reducing risk through offsetting positions, derivatives, or options.
Note that each hedge fund strategy has its own risk-reward profile and market focus.
Hedge Funds in India
Though still a niche segment, hedge funds in India have started gaining traction. Under SEBI regulations, many Indian hedge funds operate as Category III Alternative Investment Funds (AIFs).
These funds use complex trading strategies and are subject to stricter norms than mutual funds. They often appeal to ultra-HNIs seeking uncorrelated, alpha-generating investments.
How Hedge Fund Managers Make Money
A hedge fund manager earns money in two primary ways:
Management Fee: Charged on assets under management (AUM), typically 1–2%.
Performance Fee: A share of the profits, usually around 20%.
This structure motivates managers to outperform the market but also makes hedge funds more expensive than traditional investments.
Things to Know Before Investing in Hedge Funds
Before considering hedge fund investment, keep these points in mind:
Minimum Investment: Often starts at ₹1 Crore or more in India.
Lock-in Periods: You may not be able to exit your investment for a year or more.
Transparency: There may be Limited visibility of fund holdings and strategies.
Fees: Relatively higher costs due to active management.
Risk Profile: Hedge funds can be highly leveraged and speculative.
They’re suitable only for sophisticated investors who understand and accept high-risk, high-reward dynamics.
Explore Sophisticated Investment Opportunities in hedge funds
Hedge funds are complex but powerful investment vehicles designed to generate returns in all market conditions. By using aggressive and often unorthodox strategies, hedge funds can deliver significant profits—but with equally significant risks.
If you’re considering hedge fund exposure, understanding the hedge fund meaning, strategy, fee structure, and eligibility is crucial. For most investors, hedge funds are best approached through informed advice and careful allocation within a broader portfolio.
Start your investment journey with HDFC Bank’s 2-in-1 Demat Account, seamlessly integrated for efficient investing and informed decision-making.
FAQs
Do hedge funds charge fees?
Yes, hedge funds typically use the “2 and 20” model—2% annual management fees and 20% of any profits earned above the set watermark or threshold.
Who can invest in hedge funds?
In India, hedge funds are open only to accredited investors such as HNIs, institutions or individuals meeting certain income/net worth thresholds.
What strategies do hedge funds Use?
Hedge funds employ diverse strategies, including hedging, contrarian strategy, quant models, global macro bets, and event-driven investing.
What is the difference between hedge funds and mutual funds?
Mutual funds are highly regulated, open to all investors and focus on relative returns. Hedge funds are lightly regulated, use advanced strategies, and aim for absolute returns. They may not be suitable for retail investors.
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*Disclaimer: Terms and conditions apply. This is an information communication from HDFC Bank and should not be considered as a suggestion for investment. Investments in securities market are subject to market risks, read all the related documents carefully before investing.
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