What are hedge funds?

These funds, like mutual funds, collect money from investors, and use the proceeds to buy stocks and bonds.

Unlike mutual funds, however, hedge funds typically take long and short positions in assets to lower portfolio risk arising from broad market movements. How?

A hedge fund may take long positions in certain stocks and short positions in certain other stocks such that their portfolio beta is close to zero. A beta close to zero means that the portfolio will remain relatively unchanged due to the broad market movement. Such a portfolio will primarily change if the stocks move more than the broad market.

Consider, for instance, Hero Honda and Bajaj Auto. The hedge fund may buy Bajaj Auto and short Hero Honda, such that the portfolio beta is close to zero. Suppose Bajaj Auto moves up by 10 per cent, and Hero Honda and the broad market move up by 7 per cent. The fund's net gain is 3 per cent. This is because Bajaj Auto outperformed the market, precisely what the hedge fund was betting on when it constructed the portfolio.

In short, hedge funds generate security-specific returns, and attempt to lower market risk. Notice that a mutual fund would have gained 10 per cent if it had invested in Reliance.

To improve their security-specific returns, hedge funds leverage their portfolio. The fund may collect, say, Rs 100 crore from investors, borrow Rs 50 crore, and invest Rs 150 crore.

In the above instance, an un-leveraged fund may have gained only 3 per cent of Rs 100 crore. But a hedge fund that has borrowed Rs 50 crore will gain 3 per cent on Rs 150 crore less interest cost on Rs 50 crore.

So hedge funds are always profitable.