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The Alter-NATIVE series Abc of hedge funds

Abc of hedge funds

Often Category-III AIFs are often synonymous with hedge funds, but in practice, there are two kinds of Category-III funds – long only funds and pure hedge funds.
Rosevina Gonsalves Dec 1, 2017

Category III AIF more popularly known as hedge funds have been flavour of this season as the category has mopped up Rs.8500 crore in Jan-September 2017, which is double of what these funds raised in the entire 2016.

SEBI defines category III as, “AIFs which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives.”

Often Category-III AIFs are often synonymous with hedge funds, but in practice, there are two kinds of Category-III funds. First, there are long only funds where the AIF fund managers run thematic long only ideas to pool money with the ease of a mutual fund but with lighter restrictions. Second, there are true hedge funds, which use strategies far more complex than a typical mutual fund that mostly focuses on generating returns through simple asset allocation. These funds use strategies such as long-short derivatives and leverage to give returns with minimum risk.

Currently, hedge funds are evolving on two main tracks: funds that are an alternative to equity and funds that are an alternative to fixed income in a client’s asset allocation. Equity alternatives offer similar or higher upside than an equity mutual fund but with reduced risk while fixed income alternatives offer higher yields than a debt mutual fund with the same consistency and capital preservation focus. Both categories of funds are characterized by an emphasis on absolute returns rather than returns relative to a benchmark – which is the focus of mutual funds.

Here are some SEBI guidelines on hedge funds:

  • These funds possess an ability to leverage therefore all information  regarding  the  overall  level  of leverage  employed,  the  level  of  leverage  arising  from  borrowing  of  cash,  the  level  of leverage arising from position held in derivatives or in any complex product and the main source of leverage in their fund should be communicated to the investors.
  • Also, the leverage of a Category III AIF should not exceed 2 times the NAV of the fund.
  • Hedge funds cannot invest not more than 10% of its investible funds in a single security.
  • For Category III AIFs, the continuing interest shall be not less than 5% of the corpus or Rs. 10 crore, whichever is lower.
  • NAV of hedge funds will be disclosed to the investors at intervals in a quarter  for  close  ended  Funds  and  at  intervals  in a  month  for  open ended funds.

Here are some common features of hedge funds

  • It includes funds, which aim to generate short term returns.
  • Includes funds which employs diverse or complex trading strategies and use leverage by investing in listed or unlisted derivatives.  
  • These funds can be open end or closed end in structure.
  • Such funds are regulated through issuance of directions regarding areas such as operational standards, conduct of business rules, prudential requirements and restrictions on redemption, conflict of interest that are specified by SEBI.
  • Continuing interest: The AIF regulations require the sponsor or the manager of an AIF to contribute a certain amount of capital to the fund. This portion is known as the continuing interest and will remain locked-in the fund until distributions have been made to all the other investors in the fund.

Taxation

While Category I AIF and Category II AIF enjoy the tax benefits of pass-through status, Category III AIF has still not been accorded a pass through status, which means that income from such funds will be taxed at the investment fund level and the tax obligation will not pass through to the unit- holders. In other words, AIFs opt to pay tax at the fund level and then treat the income as exempt for the investors.

Commission

AIFs typically offer an upfront commission in the range of 2% to 3% to distributors depending on the type of AIF. However, the structure and quantum may vary from fund to fund.

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