Hedging in PMS and AIF: What It Means and How Fund Managers Use It

When evaluating a long-short AIF or a Specialised Investment Fund (SIF), you will often come across the term what is hedging in investing. While many investors are familiar with the concept, understanding the hedging meaning in the context of Indian PMS and AIF products helps you assess how effectively a fund manages downside risk. This article explains how hedging works, the most common strategies used by Indian fund managers, and how well-hedged portfolios can behave differently during periods of market stress, such as the March 2026 Nifty correction of 11.30%.

What is Hedging? Plain Language Definition

The hedging meaning is simple: it is the practice of taking an offsetting investment position to reduce the risk of losses in another investment. Understanding how hedging works is easier if you think of it as insurance. A hedge is designed to gain value when the primary investment declines, helping offset part of the loss. Like insurance, hedging comes at a cost, which can reduce returns if markets continue rising. Rather than eliminating all risk, most professional fund managers use partial hedges, balancing downside protection while retaining meaningful upside potential.

Hedging - At a Glance

Aspect	Explanation
Definition	Reducing the risk of an adverse price move by taking an offsetting position.
Purpose	Protect portfolio value during market declines or specific risk events.
Cost	Hedging carries a cost, such as option premiums or the opportunity cost associated with futures positions.
Effect on Returns	Active hedging generally reduces both downside losses and upside gains while the hedge remains in place.
Common Instruments in India	Futures contracts, put options, collars, and swaps on stocks and indices in the NSE and BSE F&O segment.
Commonly Used In	Category III Long-Short AIFs, SIFs (within the applicable regulatory framework), and select long-only AIFs using tail-risk hedging strategies.

Types of Hedging Used in Indian Investment Products

Professional fund managers use different hedging techniques depending on the investment strategy, market outlook, and regulatory framework. In India, hedging is primarily implemented through derivatives traded on the NSE and BSE Futures and Options (F&O) segment. The objective is not to eliminate risk completely but to reduce portfolio volatility while maintaining the potential for long-term returns.

1. Futures-Based Hedging

One of the most widely used forms of futures hedging India is selling index or stock futures to offset the risk of a long equity portfolio. Suppose a fund owns Rs 10 crore worth of equities and expects short-term market volatility. Instead of selling quality stocks, the fund manager may sell Nifty futures worth Rs 3 crore, creating a partial hedge.

If the Nifty declines by 10%, the equity portfolio could lose around Rs 1 crore. However, the short futures position may gain approximately Rs 30 lakh, reducing the overall portfolio loss to about Rs 70 lakh. This allows the fund to remain invested while cushioning downside risk.

Unlike options, futures do not require an upfront premium. Instead, fund managers must maintain margin with the exchange, and positions are marked to market daily. This makes futures an efficient but actively managed hedging tool.

2. Options-Based Hedging (Put Options)

Another common strategy is options hedging India, where fund managers purchase put options on the Nifty or individual stocks. A put option gives the holder the right, but not the obligation, to sell an asset at a predetermined strike price before expiry.

The primary cost is the option premium, which is paid upfront. For example, buying a Nifty 22,000 put option may cost roughly 1% to 2% of the portfolio value, depending on market volatility and the option's maturity.

If the Nifty falls sharply to 18,000, the value of the put option rises significantly, helping offset losses in the equity portfolio. Unlike futures, the maximum loss for the investor is limited to the premium paid, while downside protection increases as markets fall below the strike price. This asymmetric payoff makes put options a popular choice during periods of heightened uncertainty.

3. Long-Short Position Pairs

Long-short strategies form the backbone of many Category III AIFs. Instead of relying only on market direction, fund managers simultaneously buy stocks expected to outperform and sell short stocks expected to underperform, with the short exposure created using eligible F&O instruments.

The portfolio's net exposure is calculated by subtracting the value of short positions from long positions. For example, a portfolio with 70% long exposure and 30% short exposure has a 40% net long exposure. A market-neutral strategy may hold roughly equal long and short positions, resulting in close to zero net market exposure.

During the March 2026 Nifty correction of 11.30%, a well-constructed long-short portfolio would have benefited from gains on its short positions, offsetting part of the decline in its long holdings. The focus is not on predicting every market move but on generating returns from stock selection while reducing overall market risk.

4. Currency Hedging (for GIFT City Funds)

Currency hedging is particularly relevant for investors accessing USD-denominated investment opportunities through GIFT City funds. For most NRI investors who already hold and invest in US dollars, additional currency hedging is generally unnecessary because both investments and future withdrawals remain in the same currency.

For resident Indian HNIs investing through the foreign currency route, however, exchange rate movements become important. If the Indian rupee appreciates against the US dollar, USD-denominated returns convert into fewer rupees, reducing realised gains. Currency hedging can help mitigate this risk, although many GIFT City investors choose not to hedge actively, especially when investing with a long-term horizon.

Hedging in Long-Short AIF (Category III)

The defining feature of Category 3 AIF hedging is the ability to hold both long and short positions simultaneously. Long positions represent stocks the fund manager expects to appreciate, while short positions are created using futures and options on eligible securities that are expected to underperform. In a long short fund hedging India strategy, the short book itself acts as the hedge by reducing the portfolio's overall market exposure.

For example, consider a Category III AIF managing a Rs 100 crore portfolio with Rs 70 crore invested in long positions and Rs 30 crore in short positions. Although the fund has deployed Rs 100 crore in investments, its net market exposure is only Rs 40 crore, or 40% net long.

If the broader market declines by 10%, the portfolio is theoretically exposed to only 40% of that market movement, resulting in an approximate 4% decline before considering stock selection and other factors. At the same time, gains from the short positions can help offset losses in the long portfolio. This flexibility allows Category III AIFs to seek returns across different market environments rather than relying solely on rising equity markets.

Hedging in SIF - The 25% Rule

An important aspect of the SIF hedging strategy is understanding how SEBI treats derivative exposure. Under the current framework, Specialised Investment Funds (SIFs) may take net directional or speculative derivative positions up to 25% of the scheme's Net Asset Value (NAV).

However, there is an important distinction. Genuine hedging positions are excluded from this 25% limit. In other words, derivatives used specifically to reduce portfolio risk do not consume the permitted speculative exposure.

This gives SIF managers significantly greater flexibility in managing downside risk. For instance, a manager may choose to hedge a substantial portion - or even the entire equity portfolio during periods of heightened uncertainty - while still remaining within SEBI's regulatory framework. The 25% cap applies only to speculative or net directional derivative positions, not to risk-reducing hedges.

For investors, this means the headline 25% derivatives limit should not be interpreted as a limit on portfolio protection. A well-managed SIF can employ extensive hedging when market conditions warrant it, helping reduce volatility while continuing to pursue its long-term investment objectives.

Hedging vs Shorting - What Is the Difference?

The hedging vs shorting difference lies in the objective behind the trade. Shorting is a directional strategy where an investor sells a stock or index because they expect its price to decline. If the price falls, the short position generates a profit. Hedging, on the other hand, is a risk management technique. The purpose is not to profit from a market fall but to reduce losses on an existing investment portfolio.

For example, a fund manager who sells Nifty futures against a diversified long equity portfolio is not necessarily predicting a market crash. Instead, the futures position acts as insurance, helping cushion the portfolio if markets weaken. In practice, many Category III long-short AIFs combine both approaches. Some short positions are established to hedge overall market risk, while others reflect the manager's conviction that specific stocks are likely to underperform, creating an additional source of alpha.

What Hedging Means for HNI Investors

For portfolio hedging HNI India, understanding how a fund implements hedging is often more important than simply knowing that it uses derivatives. When evaluating a long-short AIF or SIF, investors should look beyond marketing terms such as "hedged portfolio" and ask a few practical questions.

1. What is the fund's current net exposure?Net exposure is calculated by subtracting short positions from long positions. A market-neutral strategy with close to 0% net exposure is heavily hedged, whereas a portfolio with 80% net long exposure remains largely dependent on rising equity markets despite having some hedging in place.
2. How did the short book perform during the last major market correction?A useful reference point is the March 2026 Nifty decline of 11.30%. Reviewing how the short positions contributed during that period provides insight into whether the fund's hedging strategy delivered meaningful downside protection when it mattered most.
3. What is the cost of hedging?No hedge is free. Option-based strategies require premium payments, while futures-based hedges can reduce gains during strong bull markets. Investors should understand whether the protection offered justifies the potential drag on returns during flat or rising markets.

Ultimately, effective hedging is not about eliminating risk altogether. It is about managing volatility, protecting capital during adverse market conditions, and improving the consistency of long-term portfolio outcomes. For HNIs allocating capital to sophisticated investment products, understanding these trade-offs is an important part of selecting the right fund strategy.

Frequently Asked Questions

What is hedging in investing?

What is hedging in investing? It is the practice of taking a position in one investment to reduce the risk of losses in another. In simple terms, hedging acts like insurance for your portfolio, helping cushion the impact of adverse market movements. While it can reduce downside risk, it also comes with a cost and may limit upside returns.

How do long-short AIF funds hedge?

Long-short AIFs hedge by combining long equity positions with short positions created using futures or options. When markets decline, the short positions typically gain value, helping offset losses in the long portfolio. The effectiveness of the hedge depends on the fund's net market exposure and how well the short positions are constructed.

What is the hedging limit in SIF?

Under the current SEBI framework, the 25% derivatives exposure limit for Specialised Investment Funds applies only to net directional or speculative positions. Genuine hedging positions are excluded from this limit, allowing SIF managers to hedge a much larger portion of the portfolio when market conditions require additional downside protection.

Is hedging the same as shorting?

No. Shorting is a directional strategy where an investor profits if a stock or market declines. Hedging, on the other hand, is a risk management technique designed to protect an existing investment portfolio from adverse price movements. While both may use similar derivative instruments, their objectives are fundamentally different.

Does hedging guarantee no losses?

No. Hedging reduces risk but does not eliminate it. A partial hedge can soften the impact of market declines, while a full hedge may significantly reduce both losses and potential gains. Investors should also remember that hedging has a cost, such as option premiums, which can reduce overall returns during stable or rising markets.

Conclusion

Hedging is one of the most important risk management tools used by professional fund managers to help protect portfolios during periods of market volatility. Whether through long-short Category III AIFs or Specialised Investment Funds, well-executed hedging strategies can reduce downside risk and improve portfolio resilience compared with unhedged investments during market corrections. For HNI investors, understanding how a fund manages its derivatives exposure, net market exposure, and short positions is just as important as evaluating its historical returns. Through its curated Long-Short AIF and SIF offerings, ALTPORT helps investors evaluate sophisticated strategies based on portfolio construction, risk management, and long-term investment objectives.

Disclaimer: Investments in PMS, AIFs, SIFs, derivatives, and other market-linked products are subject to market, liquidity, and regulatory risks. Hedging strategies reduce risk but do not eliminate the possibility of losses. Any examples provided are illustrative and should not be interpreted as guaranteed outcomes or investment advice. Investors should consult a qualified financial advisor before making investment decisions.