A hedge fund is a type of investment product that is typically formed by pooling investments from multiple investors. They are private investment funds that generate high returns by investing in non-traditional assets. In India, the classification is Alternative Investment Funds (AIF). 

According to Securities & Exchange Board of India (SEBI), ‘Hedge Funds including fund of funds, are unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are not subject to the same regulatory requirements as mutual funds.

Hedge funds, as the name implies, are intended to "hedge" against market risk. Their investment strategy and fund management are geared toward generating returns while minimising risk. However, as times changed, so did the strategies involved, and hedge funds are now more risky than mutual funds and other saving instruments.

Salient Features of Hedge Funds

• One of the primary goals of hedge funds is to generate market-neutral returns. Diversification of investment portfolios and trading strategies allow for returns in both market trends (up and down).

• They use leveraging and borrowing techniques to increase profits and returns. However, in India, consent from hedge fund investors is required before borrowing money for investment purposes.

• Hedge funds in India are less regulated than their counterparts, such as mutual funds and other financial instruments.

• As there are no restrictions on investment avenues, hedge funds invest in almost any type of financial instrument. They invest in a variety of investment vehicles such as land, real estate, equities, and debt securities, which significantly reduces risk. This greater investment flexibility is what distinguishes hedge funds from traditional investment vehicles.

• Hedge funds charge an asset management fee in addition to a performance fee. Internationally, they charge 2% of total assets as an expense fee and 20% of total returns as a performance fee. As a result, hedge funds are a slightly more expensive investment option. There is no set fee in India. The expense ratio can be as low as 2%, and the performance fee ranges from 10% to 15% of the returns generated.

• In India, the minimum investment in hedge funds is one crore rupees. This is a prohibitively large sum for retail investors, who would prefer to invest in mutual funds through the Systematic Investment Plan (SIP).

Hedge Funds in India

The Securities and Exchange Board of India first introduced hedge funds in 2012. The SEBI (Alternative Investment Funds) Regulations 2012 mandated its implementation. In India, it falls under Alternative Investment Funds (AIF) Category III. These funds are in their infancy and are currently unregulated.

As per SEBI (Alternative Investment Funds) Regulations, 2012; “Alternative Investment Fund” means any fund established or incorporated in India in the form of a trust or a company or a limited liability partnership or a body corporate which,-

1. Is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors; and

2. Is not covered under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, Securities and Exchange Board of India (Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to regulate fund management activities.

It is not taxed separately under any laws. They are subject to AIF taxation. This could be one of the reasons why the hedge fund industry has yet to catch up to the industry in Western countries. The taxation on hedge funds is heavy in India. They come under the Category III of AIF, the tax rate is 42.74% on annual earnings over INR 5 crores. 

Regulatory Framework

The key regulations include the;- 

• AIF Regulations, 

• SEBI (Foreign Portfolio Investor) Regulations 2019, 

• SEBI circulars, issued from time to time, prescribing additional compliance and reporting requirements, 

• Foreign Exchange Management Act 1999 and regulations and circulars issued thereunder by the Reserve Bank of India (RBI) from time to time, regulating investments by offshore investors/hedge funds into onshore hedge funds.

Risk

Category III funds (AIFs) are required to disclose risk management tools in order for investors to be placed in the memorandum. Furthermore, all category III funds are required to provide disclosure about the risks and how they will be managed:

• At the funding level, there is a risk.

• At the funding level, there is a risk of foreign exchange.

• Leveraging risk at both the funding and investee levels.

• The change in the environment at the exit stage in terms of funding and investee levels.

• The shift or divergence from business in terms of funding and investee levels.

• The reputational risk of the investee

• Changes in politics, the environment, society, and technology

Pricing

A description of the valuation procedure and method for valuing assets must be included in the Private Placement Memorandum (PPM). Details on the method of valuation must also be included in the annual report distributed to investors. Furthermore, for close-ended Category III AIFs, the net asset value (NAV) must be disclosed to investors quarterly, and for open-ended Category III AIFs, it must be disclosed monthly.

Insider Trading & Market Abuse

The SEBI (Prohibition of Insider Trading) Regulations 2015 (PIT Regulations) establish the framework for prohibiting and punishing insider trading. The PIT Regulations make it an offence to communicate or obtain unpublished price sensitive information (UPSI) (a concept similar to material non-public information) or to trade in securities while in possession of UPSI. SEBI advised employees of AIF schemes in an Informal Guidance issued in October 2018 that they can invest in units of the AIF subject to the requirements specified in the AIF's internal regulations, and in the case of investment in listed securities (or securities proposed to be listed), subject to the code of conduct set by the AIF under the PIT Regulations.

The SEBI (Prohibition of Fraudulent and Unfair Trade Practices in the Securities Market) Regulations 2003 prohibit dealing in securities in a fraudulent or unfair manner and manipulating the price of securities. Hedge funds, which trade in publicly traded securities, are subject to the regulations governing insider trading and fraudulent securities dealing. It is worth noting that SEBI introduced an "informant mechanism" under the PIT Regulations in September 2019, thereby strengthening its powers to gather better evidence, crack down on insider trading cases, and protect informants.

Transparency

SEBI Regulations require these alternative funds disclose the several of the information to the investors to ensure transparency, which are listed as the following –

• Financial, risk management, operational, portfolio, and transactional information about investment funds must be disclosed to investors on a regular basis.

• Fees ascribed to the manager or any fees charged to alternative funds or any such investees by an associate, manager, or such persons are now critical to the investor and must be disclosed to the investor.

• Inquiries or legal actions taken by legal or regulatory concerns, as and when they occur in relation to any jurisdiction.

• Any material liability arising during the tenure of the alternative funds must be disclosed as and when it occurs.

• A breach of such provisions of the placement memorandum, agreement with the investor, or any other fund agreements, as and when they occur.

Money Laundering

The Prevention of Money Laundering Act of 2002 governs the offences of money laundering (PMLA). Among other things, this legislation addresses the prevention and control of money laundering, as well as the confiscation and seizure of property obtained through the laundering of money. Hedge funds are subject to the PMLA's anti-money laundering obligations, as well as other compliance and reporting obligations imposed by SEBI and the Reserve Bank of India via circulars issued by each of them.

Marketing

The funds must be marketed through a private placement under the aforementioned legislation. There is a person who is described as an investment advisor, and he or she is thus registered. These are SEBI provisions, and the managers of these funds are also exempt from the registration requirements set forth in the aforementioned regulations.

Indian laws do not specifically mention restrictions on the investors who are subject to these alternative funds. These funds can be sold to sophisticated investors such as institutions and high-net-worth individuals. Foreign hedge funds, on the other hand, cannot be marketed in India.

Restrictions & Portfolio

There are no restrictions on local investments in an alternative investment fund in the scenario of local investors investing in a hedge fund (AIF). Such funds, however, are not aimed at retail investors. As a result of these regulations, an investor must invest at least INR10 million in the AIF. Furthermore, employees and directors of alternative fund investment managers must invest at least INR2.5 million in the AIF. Employees and directors of investment managers, on the other hand, are exempt from AIF investment for any performance fees.

These regulations require that a custodian’s appointment is made by the sponsor or manager of such a category of funds. This must maintain the portfolio of assets and of such a category of funds. This custodian is governed by the SEBI (Custodian of Securities) Regulations 1996.

Eligibility Criteria for Hedge Fund Registration in India

• The memorandum of association in case of a company; or the Trust Deed in case of a Trust; or the Partnership deed in case of a limited liability partnership permits it to carry on the activity of an Alternative Investment Fund

• The applicant is prohibited by its memorandum and articles of association or trust deed or partnership deed from making an invitation to the public to subscribe to its securities

• In case the applicant is a Trust, the instrument of trust is in the form of a deed and has been duly registered under the provisions of the Registration Act, 1908

• In case the applicant is a limited liability partnership, the partnership is duly incorporated and the partnership deed has been duly filed with the Registrar under the provisions of the Limited Liability Partnership Act, 2008

• In case the applicant is a body corporate, it is set up or established under the laws of the Central or State Legislature and is permitted to carry on the activities of an Alternative Investment Fund

• The applicant, Sponsor and Manager are fit and proper persons based on the criteria specified in Schedule II of the Securities and Exchange Board of India (Intermediaries) Regulations, 2008

• The key investment team of the Manager of Alternative Investment Fund has adequate experience, with at least one key personnel having not less than five years experience in advising or managing pools of capital or in fund or asset or wealth or portfolio management or in the business of buying, selling and dealing of securities or other financial assets and has a relevant professional qualification

• The Manager or Sponsor has the necessary infrastructure and manpower to effectively discharge its activities

• The applicant has clearly described at the time of registration the investment objective, the targeted investors, proposed corpus, investment style or strategy, and proposed tenure of the fund or scheme

• Whether the applicant or any entity established by the Sponsor or Manger has earlier been refused registration by the Board

Bibliography

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List of major hedge fund firms in India- https://www.aurigininc.com/c/India/Hedge-Funds/IN/1/All/1