HEDGE FUNDS - Investment Guide Series Part 3

Hedge fund is a pooled fund of mainly high net worth individuals, institutional investors like banks, insurance companies, mutual funds etc. Basic concept of Hedge funds is same as of mutual funds as these are also pooled funds of many investors with an aim of investing large sum of money with the help of competent and professional managers to maximize the gains on investments. But hedge funds are different from mutual funds in many ways.

  ü Hedge funds are not regulated by the market regulator as SEBI in India.

  ü Hedge funds are not required to disclose their NAV daily or weekly as in case of mutual funds.

  ü Hedge funds are more aggressively managed by fund portfolio managers.

  ü Hedge funds mainly pool funds of investors with high income appetite and high risk bearing capacity. So in hedge funds only HNIs and institutional investors pool their money.

  ü Hedge funds charge high management fee and performance fee also which is not seen in case of traditional mutual funds.

As the term Hedge means to take steps for averting or minimizing the potential risk. In case of hedge funds the investment fund manager uses different trading strategies to earn and safeguard the investment. These hedging tricks and strategies are employed to reduce the risk. For example if a fund manager for sees a market rise or rise in a particular stock price and keeps long positions (buying). Then some short position may be made in futures and options (F & O) of same stock or index as per situation. It would help to minimize the loss in case the market or the stock price goes in opposite way.

            However the hedging technique is to be employed with due care and a proper check is needed considering the market positions time to time otherwise it may lead to increased risk. Generally management of hedge funds invests funds in alternative instruments like derivatives (F & O), equity, currencies, bonds etc. Fund managers of Hedge funds need to be very attentive for monitoring the market situation and results of the strategy employed. They need to be aggressive about changing their strategy according to changes in market situation. If the strategic move goes successful the earnings are quiet high in terms of return on invested amount as in case of F & O deals of large amounts are done with 20 to 30 percent margin only. In case of successful transaction the gain is on full value not only on the margin invested. But the risk is also very high if the employed strategy does not work and takes a U Turn. So the fund managers in case of hedge funds need to be more aggressive, vigilant, knowledgeable and competent then in case of traditional mutual funds. Due to this fact the management expenses of hedge funds are much higher than traditional mutual funds. Accordingly the management fee charged by the hedge funds from its investors is very high. The structure of investment portfolio of hedge funds is generally very wide and highly diversified comprising of equity, currency, funds and their derivatives. So the management of hedge funds also charges 10 to 20% of profits along with management fee of 1 to 2%.

             

Apart from involvement of high risk investing style in case of hedge funds the locking period is also long. Hedge funds also employ leveraged or borrowed funds along with funds invested by pooling HNIs and financial institutions. The borrowed funds bear fixed cost in the form of interest which is to be paid even if the fund performance is poor and in loss. Due to this fixed interest cost the losses of hedge funds aggravate and investors may lose their investments substantially. This is the reason the investors of hedge funds are of high risk bearing capacity.

Hedge fund managers generally employ following strategies:-

1.     Directional Strategy

2.     Long and Short bias

3.     Bottom up

4.     Top down

5.     Arbitrage

6.     Opportunistic

List of Indian market based Hedge funds:-

1.     Monsoon capital equity value fund

2.     India Capital Fund

3.     India Deep Value Fund

4.     Absolute India fund

5.     India Capital Pte. Ltd.

6.     Atlantis India Opportunities Fund

7.     Passport India Fund

According to various reports Hedge funds in India are giving better returns in comparison to other countries. Average annualized return on hedge funds during past 6 years is nearly 18%.  In this article we have discussed various pros and cons of Hedge funds to give basic knowledge and understanding of a not so widely known instrument of investment.  In our next article we will discuss about some more innovative modern day mutual funds.

INVESTMENT GUIDE SERIES: PART 2 BASIC KNOWLEDGE OF INVESTING IN MUTUAL FUNDS

TYPES OF MUTUAL FUNDS

IN PART OF THE SERIES WE HAVE ALREADY SHARED information about the basic concept of mutual funds and basic precautions that should be taken by the investors while investing their earnings or funds in mutual funds. The popularity of mutual funds  is increasing day by day. In present time, investing in mutual funds has evolved as a new avenue for investing funds where investors can earn a handsome earnings with lesser risk. We are doing a sincere effort to make our readers aware about various aspects of investing in mutual funds. So, here in this Investment Guide Series, Part -2, we are discussing about types of mutual funds.

Classification of mutual funds may be done on various basis or criteria. It may be based upon asset class, time of entry for retail investors or type of returns from Mutual fund managing companies.

Based on Asset class:  This classification of mutual fund is done on the basis of investment/securities or assets where the pooled funds of the participants are invested.

(a) Equity funds: if the funds are invested in Equity stocks/shares then such mutual funds are called equity funds. Equity funds are considered risky and as per the rule of economics (more risk, more profit) also  give more profit.

Although equity funds are not as risky as investing funds directly in Equities, yet risk involvement is high in comparison to debt funds.

(b)  Debt funds: Mutual fund in which money is invested in bonds, government securities, and other securities where risk is less as per the rule of economics (less risk less profit) returns are also less.

(c) Hybrid or balanced funds: In balanced or Hybrid funds, the pool funds are invested in a mix proportion of equity and debts. In case of hybrid or balanced funds the risk is lesser than equity funds and the returns are higher than debt funds.

(d) Money market fund: Pooled funds are invested in liquid investments or the assets which may be converted to money at a short call.
Example: Commercial Papers (CP).

(e)  Indexed Fund: Indexed Fund invest money in index like BSE, Nifty or the shares which represent a particular index like the shares which represent Nifty.

(f) Sector funds: These funds invest in a particular sector financial assets. For example: A banking sector fund would invest its funds mainly in banking companies' instruments. Return on investment or risk both mainly depend upon the performance of that particular sector in economy.

CLASSIFICATION BASED ON THE TIME OF ENTRY IN THE FUND :

Based upon entry timing in the fund, Mutual funds are classified mainly into two parts.

1) Open ended funds: In case of open ended funds, investors can purchase or redeem their units at any time during the year at the value on that particular time. So, these funds provide more liquidity to their investors.

2) Close ended funds:  In close ended mutual funds the purchase of units can be done by the investors during a fixed period at the time of creating or initiating that particular fund. The redemption of units can also be done at a specific maturity date, no sale/ purchase of units is directly done by these mutual funds. But these mutual fund schemes are usually exchange traded which means the units of these funds may be sold on stock exchange to other willing investors.

CLASSIFICATION BASED ON TYPE OF RETURN

1) Growth funds: These mutual funds focus on fast and steep growth of the invested funds. Normally these funds invest the pooled money in equities. Generally, high growth is associated with high risk and same economic law applies to growth funds also.

2) Income funds: This type of mutual funds promise a fixed income to investors on their money invested. To keep their promise these funds invest the pooled money in fixed income instruments like debentures, bonds etc. Here the investors get regular income which is nearly in a fixed range. The income potential is much lower in comparison to growth funds but at the same time the associated risk is also low. Rate of interest and inflation rate are the major factors which affect the performance of income funds. As we do not witness very steep changes in the rate of interest within a very short period, so the variation in the income of these funds is also generally range bound.

Balanced funds: these are a mix of growth funds and income funds, where a part of the investor's pooled money is invested in equities and the other part is invested in fixed income instruments. These funds offer a moderate return which is associated with moderate risk.Investing in mutual funds is considered to be less risky and more beneficial for investors.

Attributes like professional management, availability of various options for diversification, availability of tax deduction make mutual funds attractive for investors. The investments may be done in small amounts which make mutual funds affordable for small investors also. Units of mutual funds may be redeemed anytime and the investment maybe converted to liquid funds in a very short time period. Liquidity is also a very important attribute of investing in mutual funds. Safety and transparency are also important issues for investors of mutual funds which have also been addressed as in India mutual funds are regulated by Securities and Exchange Board of India (SEBI). There is a continuous monitoring mechanism, even then the investors are advised to be cautious and monitor the performance of funds on timely basis.

Income from Capital Gain- Part-I

Income from capital gain is one of the five income heads as given in the Income Tax Act, 1961 in India. The definition of income from capital gain:-

 “Any profit or gain arising from transfer of capital asset held as investments is said to be capital gain income and it is chargeable to tax under the head income from capital gains”

From the above definition following questions arise:

a)     What is a capital asset?

b)    When capital asset is said to be transferred?

c)     How the profit or gains are calculated on transfer of capital asset?

d)    The calculation of tax there upon.

e)     How the capital gain tax can be saved?

Capital assets:–

Following assets are considered as capital assets:

1)    Land (excluding rural agricultural land)

2)    Building

3)    House property

4)    Vehicles

5)    Patents and trademarks

6)     Shares

7)    Leasehold rights

8)    Plant and machinery

9)    Jewelry

Capital Asset does not include:-

1)    Any item held as stock, consumables or raw material for the purpose of business or profession.

2)    Personal goods, house hold material i.e. furniture at house, clothes, utensils, etc.

3)    Rural agricultural land:

Whether the Agriculture Land will be considered Rural or Urban agriculture Land depends upon the situation of land and distance from municipal limits.

Following table will help to understand when agriculture land is said to be Rural and is not considered a capital asset:

Population of Municipality	Capital Asset / Urban agriculture land	Not Capital Asset / Rural Agriculture land
More than 10000 but less than 100000	Within 2 KM from Municipal Limits	Outside 2 KM of Municipal limits
More than 1lakh but less than 10 lakhs	Within 6 Km	Outside 6 KM
More than 10 lakhs	Within 8 KM	Outside 8 KM

for calculating capital gain income and tax thereupon the capital assets are further classified into long term capital assets and short term capital assets based upon the holding Period of the assets by the assessee.

1.     Long term capital assets - Any asset other than shares and securities which is held for more than 36 months is long term capital assets. The time period of 36 months has been changed to 24 months from F.Y. 2017-18. So if an asset has been sold up to 31.03.2017, then it will be considered long term capital asset, if it was held for more than 36 months by the taxpayer. In case the capital asset is sold after 31.03.2017, then it will be said to be long term capital asset if was held for more than 24 months by the taxpayer.

                  In case of shares and securities, the holding period for classification of short term and long term capital assets is 12 months. If the holding period is more than 12 months ,then the shares ,securities , mutual funds etc. are said to long term capital assets.

2.     Short term capital assets -Any capital asset which is not long term capital asset is known as short term capital assets if shares and securities are held for less than 12 months, and for other assets are held for less than 36 months (24 months if asset is sold after 31.03.2017), then the capital asset is classified as short term capital asset .

TRANSFER OF A CAPITAL ASSET: In relation to capital asset, transfer includes –

1.     Sale, exchange or relinquishment of an asset or extinguishment of any rights in the asset.

2.     Compulsory acquisition of the land or any other capital asset by government or any authority.

3.     Conversion of any capital assets into stock in trade.

4.     Taking possession of any immovable property in part performance of a contract.

5.     If any transaction gives effect to transfer or enable the transferee, for enjoyment of any rights in the immovable property

6.     Maturity / redemption of zero coupon bonds.

Following is not considered transfer of Capital Asset:

If a property is transferred through will or inheritance or by way of gift then, it is not considered transfer for the purpose of calculating income from capital gain.

 Calculation of Profits or Gains on transfer of Capital Asset:-

For the purpose of understanding the calculation of profits or gains on transfer of capital asset, one should know the following terms:

1)    Sale consideration: Consideration received or receivable by transferor or seller of capital asset against the transfer of his asset. If for the purpose of transfer or sale of asset some expenses are incurred like commission on sale of property or any other incidental expenses then these expenses are deductible from the sale value to arrive at the net consideration. Capital gain is taxable in the year of transfer of asset whether the consideration of transfer is received in same year or future/past years.

2)    Cost of acquisition:  It is the cost at which the capital asset was acquired by the transfer. The cost of acquisition of the asset include other costs like stamp duty paid for registration of property, any commission paid for acquiring the property or any other incidental expenses for the purpose of the sale.

3)    Cost of improvement: Amount spent for any improvement and             enhancement of the capital asset is said to be cost of improvement of capital asset.

CALCULATION OF SHORT TERM CAPITAL GAINS

The profit or gain on sale of a short term capital asset is said to be short term capital gain. Calculation of short term capital gain is very simple.

	Full value of   consideration

 

                                                             (Subtract)

Net consideration

           Subtract                Transfer expenses

                                          (Subtract)

              

             Subtract                   ·        Cost of acquisition

                                        ·         Cost of improvement

Amount of short term Capital gains

 

·         First net consideration is calculated by subtraction of transfer expenses from full value of consideration.

·         Then, from net consideration, the cost of acquisition and cost of improvement are deducted to arrive at the amount of short term capital gain.

CALCULATION OF LONG TERM CAPITAL GAIN

In case of long term capital gain, the cost of acquisition and cost of improvement are taken after Indexation i.e. we consider indexed cost. Indexed cost of acquisition and indexed cost of improvement. In case of long term capital gains, assets are being held for long term and cost is considered to be increased on account of inflation over the period of holding the property. The effect of inflation is given by applying cost inflation index numbers of the years in which property was acquired/ improved and transferred.

Index COA   =   COA * Index no. of year of sale

                                    _______________________________________

                                          Index no. of year of purchase of property

                                           

                                                COA stands for cost of acquisition

Similarly, index cost of improvement is calculated from cost of improvement.

Calculation of Indexed cost of acquisition/improvement:        

Similarly indexed cost of improvement is calculated.

Long term capital gain is calculated as:

	Full value of   consideration

 

                                                                                                     

(Subtract)

Net consideration

                                   Transfer expenses

                                          (Subtract)

(Subtract)

                                    

·        Indexed Cost of acquisition

·         Indexed Cost of improvement

Amount of long term   Capital gains

 

·         First net consideration is calculated by subtraction of transfer expenses from full value of consideration.

·         Then, from net consideration, the Indexed cost of acquisition and Indexed cost of improvement are deducted to arrive at the amount of short term capital gain.

·        Year wise Index no. for the purpose of calculating Income from Capital gain as follows:

Year	Cost Inflation Index Number
2001-02	100
2002-03	105
2003-04	109
2004-05	113
2005-06	117
2006-07	122
2007-08	129
2008-09	137
2009-10	148
2010-11	167
2011-12	184
2012-13	200
2013-14	220
2014-15	240
2015-16	254
2016-17	264
2017-18	272
2018-19	280

2001 is taken as base year. If the asset has been purchased before 2001, then the fair market value of 2001 is to be calculated. The fair market value in year 2001 would be taken as coast of acquisition of capital asset.

Following topics related to capital gains income would be covered in our next issue.

1)    How to arrive at fair market value of Long Term Capital Asset in 2001?

2)    Calculation of capital gain tax

3)    Exemption available for tax payer to save capital gain tax.

4)    Some special cases to understand the taxation of capital gain income.