Hedge Fund

---

✅ Prelims-Oriented Questions (Objective)

---

Q1. What is a Hedge Fund?
A. A hedge fund is an alternative investment vehicle that pools capital from accredited investors and uses diverse and often aggressive investment strategies to earn active returns for its investors.

• ✅ Correct Answer: A

• Explanation: Hedge funds employ strategies like leverage, derivatives, short selling, and arbitrage to achieve returns.

---

Q2. Which of the following is NOT a characteristic of a hedge fund?
A. Open to the general public
B. High minimum investment
C. Lightly regulated compared to mutual funds
D. Use of leverage and derivatives

• ✅ Correct Answer: A

• Explanation: Hedge funds are usually limited to high-net-worth individuals or institutional investors and not open to the general public.

---

Q3. In India, hedge funds are regulated by:
A. RBI
B. SEBI under AIF regulations
C. IRDA
D. Ministry of Finance directly

• ✅ Correct Answer: B

• Explanation: SEBI regulates hedge funds under the Alternative Investment Fund (AIF) Regulations, 2012, specifically as Category III AIFs.

---

Q4. Which of the following categories of AIFs include hedge funds in India?
A. Category I
B. Category II
C. Category III
D. Category IV

• ✅ Correct Answer: C

• Explanation: Category III AIFs include hedge funds, which employ diverse or complex trading strategies.

---

✅ Mains-Oriented Questions (Descriptive)

---

Q1. What are Hedge Funds? How are they different from Mutual Funds? Discuss their regulatory framework in India.

Answer:
Hedge funds are pooled investment funds that employ non-traditional strategies like short selling, leverage, arbitrage, etc., to earn active returns.
Differences from Mutual Funds:

• Investor Base: Mutual funds are open to retail investors; hedge funds are restricted to high-net-worth individuals.

• Regulation: Mutual funds are tightly regulated; hedge funds have more flexibility and lesser regulatory burden.

• Transparency: Mutual funds publish NAV regularly; hedge funds have limited disclosure.

• Strategy: Mutual funds generally follow long-only strategies; hedge funds can short sell and use leverage.

Regulatory Framework in India:
In India, hedge funds fall under Category III AIFs, regulated by SEBI under the AIF Regulations, 2012. They have to adhere to specific norms related to disclosures, leverage, and reporting but enjoy greater operational flexibility compared to mutual funds.

---

Q2. Examine the risks and rewards associated with hedge fund investments. Should India promote their growth?

Answer:
Risks:

• High leverage can lead to significant losses.

• Illiquidity due to lock-in periods.

• Lack of transparency and regulatory oversight.

• Systemic risk due to interconnectedness with global financial systems.

Rewards:

• Potential for high returns even in bearish markets.

• Diversification from traditional investment portfolios.

• Encourage financial innovation.

Conclusion:
India can cautiously promote hedge funds with proper regulation and oversight to ensure market stability. Balancing innovation with investor protection is key.

---

Q3. Why are hedge funds often criticized despite their financial sophistication?

Answer:
Hedge funds are criticized due to:

• Lack of transparency and accountability.

• Use of high-risk strategies that may endanger financial stability.

• High fees (typically "2 and 20" model).

• Limited access for retail investors, raising equity concerns.

• Role in speculative bubbles or crises (e.g., 2008 financial crisis, GameStop short squeeze).

---

✅ Recent/Current Affairs Angle (UPSC 2025 Context)

Q. Recently, hedge funds were in the news for short-selling positions in the global stock market. Explain short selling and its impact.

Answer:
Short selling involves selling a security not owned by the investor, hoping to buy it later at a lower price. Hedge funds use this to profit from declining prices. While it adds liquidity and can expose overvalued stocks, excessive short selling can cause market instability and has raised concerns of manipulation.