As opportunities for significant gains in private markets diminish, India's wealthy investors are increasingly turning to hedge fund-style strategies. This shift is occurring as the gains in private markets cool down. These strategies offer the potential for high returns, active risk management, and better downside protection in uncertain markets.

Category III AIFs Gain Traction

Wealthy Indians are shifting towards public market-linked investment strategies, despite the higher risk, as opportunities for outsized gains in private markets fade. Domestic capital inflows into private equity- and private credit-led Category II alternative investment funds (AIFs) slumped to a five-quarter low of 4% in the April-June quarter. Conversely, Category III funds continue to attract steady inflows, outperforming Category I and II funds for the fifth consecutive quarter.

AIFs pool funds from various investors to invest in companies or projects. Category I AIFs include venture capital and infrastructure funds, while private equity and debt funds fall under Category II AIFs. Category III AIFs, which include hedge funds, have a higher risk appetite and employ aggressive investment strategies, such as algorithms for automated high-frequency stock trading.

Clarification of Tax Rules Boosts Confidence

The Delhi High Court recently clarified that Category III AIFs with clear disclosures of beneficiaries will only be subject to short-term and long-term capital gains taxes, and not an automatic maximum marginal rate of 40%. This clarification, coupled with strong distribution incentives, is expected to encourage wealth managers to increase their Category III AIF offerings this year.

Hedge Fund Strategies Explained

Hedge funds in India, typically structured as Category III AIFs, cater to high-net-worth individuals (HNIs), family offices, institutional investors, and accredited investors. These funds employ diverse trading techniques, investing in equities, debt, and derivatives such as futures and options. Minimum investment amounts are generally high, often starting from ₹50 lakhs to ₹1 crore or more. Hedge funds utilize strategies like hedging to protect investments from major losses by offsetting risks and can quickly adapt their strategies based on changing market conditions to seize opportunities or avoid risks.

Types of Hedge Fund Strategies

• Long/Short Selling: Selling a security without owning it, with the expectation of buying it back at a lower price in the future.
• Arbitrage: Buying a security in one market where it's cheaper and selling it in another where it's more expensive to profit from the price difference.
• Market-Driven: Taking advantage of global market trends before investing in securities.

Benefits and Risks

Hedge funds offer the potential for higher returns than traditional investments, regardless of market conditions. They provide active risk management, diversification, and the ability to adapt to changing market dynamics. However, hedge fund returns can be volatile, requiring investors to be prepared for both ups and downs. Hedge funds are complex in their structure and strategy. Investing in hedge funds requires careful research and alignment with investment goals. They are best suited for experienced investors who understand market complexity or have trusted advisors.

Specialized Investment Funds (SIFs)

SEBI has introduced a new investment category called Specialized Investment Funds (SIFs). These funds combine the transparency of mutual funds with the flexibility of hedge fund-style long-short strategies, providing investors with opportunities to generate returns across various market conditions. Quant Mutual Fund is the first AMC in India to receive approval to launch an SIF. SIFs can short stocks or sectors expected to underperform, offering a chance to generate returns even in falling or sideways markets. By combining long and short positions, SIFs can deliver steadier performance across bull, bear, and range-bound markets.