UNIT- V

HEDGE FUNDS AND REAL ASSETS

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HEDGE FUNDS

➢ Hedge funds are alternative investment that pools capital from

investors to invest in varied assets.
➢ Hedge means to safeguard,means to protect against risks.
➢ Uses the funds collected from accredited investors like banks,
insurance firms, High Net-Worth Individuals & families, and
endowments and pension funds.
➢ Typically open-ended

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How do Hedge Funds work?

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Alternative investment

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Advantages of Hedge Fund Investing

• The investment manager gets paid
a huge performance fee for
successfully turning large profits
on the fund, therefore he is highly
motivated to make the investment
flourish
• Hedge funds bank on the
prosperity of only one investment
and are not overly diversified
investments
• Aggressive investment
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Disadvantages of Hedge Fund Investing

• Only the wealthiest individuals can
participate in hedge funds
• Hedge funds are extremely risky
and millions of dollars can be lost
in the blink of an eye
• The performance fee for the
investment manager may
encourage them to take bigger
risks with your money
• There are very few government
regulations overseeing
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Difference between Hedge Fund & Mutual Fund

Parameter of Comparison Hedge fund Mutual fund

A mutual fund is for the people who can

In a hedge fund, only a few wealthy
invest in small or medium amounts. Most
people can invest to maximize their
Investment of the people are qualified to spend in
profits, because the minimum starting
this as the minimum investment is set to
investment amount for this is pretty high.
very low.

In this case, the investment is kept to a

The profit margin in hedge funds is pretty minimum amount, that is why profit to
Profit margin
higher than mutual funds. investment ratio also reduces because of
it’s lower risk.

Millions of people could invest in mutual

There can only be a very few wealthy
Ownership funds and can become an owner.
owners when it comes to hedge funds.

Reveals in a proper way .

Information Reveals to investors only information

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Hedge fund in India & Minimum Investment

Financial articles and Eurekahedge. In India, Hedge funds are
called as Alternative Investment Funds. There are no ratings or
performance of any AIF funds publicly available like Mutual funds.

In India, there is no specific fee. Expense ratio can be 2% or below

that as well and performance fee varies from 10% to 15% of the
returns generated. The minimum amount required for investment
in hedge funds in India is ₹1 crore.

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How Hedge funds make Money

● In addition to understanding how do hedge funds work, many
people wonder how they make money. Funds make their money by
charging fees on the assets they manage and the performance they
manage on those assets.

● The traditional fee structure for investing in hedge funds is 2 and

20, which means a management fee of 2% and a performance fee
of 20%. In other words, they charge 2% of the assets to manage
them and then 20% on performance if the assets increase in value.
Not all funds follow this structure, however. In fact, as competition
in the hedge fund industry increases, many funds have reduced
their fees to remain competitive.
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Many funds employ what's called a high-water mark, which

means that during a time when the fund is losing money, the
manager has to recover losses before they can charge a
performance fee on new profits.

Another common feature in a hedge fund's fee structure is a

hurdle rate, which means they only charge a performance fee
when the performance passes a hurdle of at least a certain
percent. For example, if a fund has a 5% hurdle rate, it will only
collect performance fees during periods when its return is
higher than 5%.
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Video on hedge Fund Mechanism

https://www.bing.com/videos/search?q=video+on+type+of+hedge
+funds&docid=607994552679411624&mid=C2991E75DFCD7DB8
FDF1C2991E75DFCD7DB8FDF1&view=detail&FORM=VIRE

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Relative value/Arbitrage strategy

➔ The strategy exploits the temporary difference in the price of the
securities.

➔ Assuming the prices will revert to true value over time, the trader will
sell short the overpriced security and buy the underpriced security.

➔ Once prices revert to true value, the trade can be liquidated at a profit.

➔ In relative-value arbitrage, an investor invests in a pair of related

securities, which have high correlations (meaning they will tend to move
in the same direction at the same time).

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How it works?

➔ When the prices of the two securities diverge (one security rises in value
and the other security falls in value), the relative-value arbitrageur buys one
security and shorts the other.

➔ When the prices converge again, the relative-value arbitrageur closes

the trade.

➔ So, relative-value arbitrage requires the knowledge and skill to

evaluate not just individual securities, but the markets as well.

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Event-Driven Strategy

➔ Event-driven strategies aim to exploit any special situation in

corporate life that may affect the valuation of a security.
➔ The special situation events could be at management, strategic or
operational levels.
➔ Investors who use this strategy employ teams of specialists who are
experts in analyzing corporate actions and determining the effect of
the action on a company's stock price.
➔ The analysis includes, analysing regulatory environment, possible
synergies from mergers or acquisitions, and a new price target after
the action has taken place.

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Example of event-driven strategy

In a bankruptcy reorganization, there might be the opportunity to

buy the debt of a company relatively cheaply and then profit if the
company is successful in reorganizing itself.

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Funds of Funds

➔ A Fund of Fund is a mutual fund scheme that invests in other

mutual fund schemes.
➔ In FoF, the fund manager holds a portfolio of other mutual funds
instead of directly investing in equities or bonds.
➔ It has high expense ratio due to individual fund expenses.
➔ It is suitable for small investors who do not wish to take higher
risk as the diversification reduces risk.

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Idiosyncratic Risk
● Unsystematic risk involved in investing in a specific asset.
● Idiosyncratic risks are rooted in individual companies or investment.
● This risk can be mitigated through diversification and hedging.

Factors of

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Selection of investment
➔ Investment Selection is the choice of the right security or fund to
best use to take a particular exposure to the targeted risk, or
asset.

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Equity hedge fund

➔ It is a hedge fund investment strategy aiming to provide equity like

returns and limiting market downside movements and volatility.

➔ The strategies of equity hedge fund can be under two different heads:

➢ Fundamental strategy
➢ Quantitative strategy

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Fundamental strategy

❏ Fundamental strategy may be geographically diverse and may be

deployed in developed or emerging markets.

❏ In their regional or sector focus managers look for opportunities either

within a specific sector(like telecommunications) or across a region.

❏ The length of holding period, amount of leveraged will be varied

based on opportunity.

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Quantitative strategy

❏ Quantitative strategy is designed to capture broad market and to

mitigate factor risk.

❏ These strategies have low net exposure and holds a large position
relatively small weights.

❏ Managers combine long position on highly attractive securities and

short position for unattractive securities.

❏ This helps to minimize unwanted portfolio risk.

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Market exposure

Market exposure refers to the absolute amount of funds or the

percentage of a portfolio that is invested in a given security, or a
bundle of securities that are part of the same industry or market
sector.
Expressed in terms of a percentage of the total portfolio
holdings of an investor. The higher the market exposure, the higher
the risk associated with the specific security, industry, sector, or
investment area.

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REAL ASSETS

➔ Real Assets are tangible assets that have an

inherent value due to their physical attributes.

➔ Examples include metals, commodities, land, and

factory, building, and infrastructure assets.

➔ They provide good returns, hedge against

inflation, lower covariance with equity investments,
and tax benefits as they can claim depreciation on
assets.

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Advantages
★ Real assets have the advantage of stability as compared to financial
assets as it have more bearing on Inflation, currency valuation and
macro-economic factors than financial assets.

★ It has a strong negative correlation with financial markets.

★ They are a good hedge against inflation.

★ Real assets are not dependent on financial market volatility.

★ Income from real assets like land, plant, and real estate projects
provide sound and steady income streams to the investors.
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Disadvantages

★ It has high transaction costs.

★ Real assets are less liquid.

★ Subject to long term capital gains tax.

★ Purchase of real assets require high capital investment.

★ They have higher maintenance costs .

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Valuation of assets

Asset valuation simply pertains to the process to determine the value

of a specific property. The valuation of assets are important because:

★ It helps identify the right price for an asset.

★ It helps in evaluating the ability of the asset for generating future cash
flows.
★ This helps an investor not to pay more for an asset than its worth.
★ This plays a crucial in decisionmaking.

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Raw land
In order to take a parcel of raw land to its highest and best use an
investor needs to consider the key valuation principles:

➢ Highest and best use

The ‘highest and best use’ principle is based on taking the land from the
current state of use to the most profitable state of use. This is done through
developing the land to the state of greatest value.

➢ Supply and demand

This principal holds that if there is a large quantity of something in the
marketplace the value of it is diminished. If there is a scarcity of that product
the value increases.
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➢ Substitution
This principal is understood by determining the value of the property
against what the cost would be to purchase a substitute property with equal
characteristics.

➢ Market value
The true market value is what a willing buyer would pay a willing seller
without undue influence.

➢ Externalities
External conditions are just one reason why land development is speculative
in nature, which means undertaking a high risk on the chance of success with no
guarantees.

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➢ Facts vs fiction
Valuation considerations must be looked at objectively by finding the true
position for the product within the marketplace, while maintaining cost control
measures.

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Valuation of Farmland

1. Factors Determining of Value Farmland

➢ Income produced on the property

➢ The size of the land market
➢ Other assets and non-farming sources of income may also
affect the value of the farm.

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Valuation of Timber
Factors Affecting Value of Timber

1. The nature of the timber

● Species, total volumes, grade, etc.

2. The nature of the tract on which the timber is located, and its
market access; and

3. The circumstances surrounding the sale.

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2. Useful Indicators for Proving Farmland Values

➢ Farm Income
● Historical Rent
● Historical Yields
● Soil Quality
● Field Quality
● Water Quality
● Tenant Quality

➢ Land market
● Number of recent sales
● Comparable sales
● Land ownership

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➢ Other assets
● Irrigation
● Shops
● Houses

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Infrastructure

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Factors affecting valuation of infrastructure

➔ Environmental performance
➔ Performance of the infrastructure
➔ Quality
➔ Efficiency

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Intellectual property

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Factors affecting value of IP

● The strength of patent claims and other IP;
● How much of a competitive advantage the IP brings its owner;
● The size and profitability of the markets for products that are
protected by the IP (and whether those products can be
brought to market);
● How the IP will be used (e.g., to improve products, as a barrier
to competitive entry, or defensively as a cross licensing tool);
and
● How rich and determined are other parties that may wish to
challenge the IP.

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Commodity Investing
● Commodities are movable goods with the following
characteristics:
- Fungible: The same no matter who produces.
- Derivatives: Involves processing into number of products.
- Economic cost: It’s production involves cost.

● Commodities are of various types like

agricultural commodities, energy, metals, etc.

● By taking advantage of the price volatility, commodities are

considered as an investment avenue.

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How To Invest In Commodities In India
1. INVEST IN PHYSICAL COMMODITIES
One mode of investing in commodity market is by physically
purchasing it. This is made in the hope that the price of the commodity
will rise and you will be able to sell it at a higher price. the best
commodities to invest in India and hold it physically are precious metals
like gold, silver, etc.

1. INVEST IN COMMODITY STOCKS

Another way to invest in commodities is to buy shares of the
companies that produce them. A commodity-producing company won't
necessarily rise or fall in line with the commodity it produces.
Commodities usually have a negative correlation or a low correlation with
equities.
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3. INVEST IN FUTURE CONTRACT

➢ Commodities futures are contracts that stipulate the price, volume, and
date of the transaction.
➢ Future contracts are traded on a commodities futures exchange.
➢ The clearinghouse buys and sells all contracts.
➢ Trading in commodity futures and options contracts is very complicated
and risky.
➢ The safest ways to invest in commodities futures are through commodity
funds.
➢ If the price of the underlying commodity goes up, the buyer of the futures
contract makes money.
➢ they can fulfill the contract by delivering proof that the product is in the
warehouse.

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4. INVEST IN COMMODITY ETFS AND MUTUAL FUNDS

Commodity ETFs and mutual funds offer commodity exposure for those
who don't want to buy the commodity directly. Commodity funds may invest in
physical materials, commodity stocks, futures contracts, or a combination.
commodity funds may not move in sync with the price of the underlying good,
which can come as a surprise to new investors.

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Private real estate and liquidity

❏ Private-market real estate and private real estate investing

refers to the universe of non-traded real estate investments.

❏ Illiquid by definition and typically characterized by investment in

a discrete property.

❏ Private-market real estate investments stand in contrast to

publicly-traded REITs (real estate investment trusts) which are
liquid but tend to correlate with public equities markets.

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Private equity is an alternative investment class and consists of

capital that is not listed on a public exchange. Private equity is
composed of funds and investors that directly invest in private
companies, or that engage in buyouts of public companies,
resulting in the delisting of public equity.

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Examples of Private equity in India

• ICICI Venture Fund Management: This is a subsidiary of ICICI bank. In the last decade, it has raised
almost 3 billion dollars.

• Kotak Private Equity Group: Kotak Private Equity Group makes investment specifically in the
healthcare and infrastructure industry in India.

• Chryscapital: It is based out of New Delhi. Since its inception in 1999, Chrys Capital has invested in
50 projects and raised almost 2 billion dollars in PE funds.

• Blackstone Group: They have been in India and aiming at infrastructure and real estate since 2006.
They have already invested around 2 billion dollars in a diversified portfolio in India.
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Valuation approaches

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Challenges

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Disadvantages of private equity

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