Are hedge funds a necessary evil

Updated: Jan 19 2007, 05:30am hrs
Statements emanating from different quarters indicate that the desirability of allowing trading by hedge funds in the country is being examined. When and under what regulatory framework would the same be introduced, if at all

Hedge funds have everywhere been the cause of animated discussions. The debate has centered on the nature of these investments, as well as their role in market mishaps. The jury is still out on the role of hedge funds during times of market stress "are they perpetrators of the crime" or are they merely "quick on the draw" to maximise their profit or minimise their loss

A hedge fund is a private investment fund open only to a limited number of very high networth investors, who are charged management fees and performance fees. The management fees are typically around 2% of the assets under management. The performance fees differentiate these funds from other pooled investment schemes such as mutual/pension funds. The performance fees characterise the investment managers prowess and are normally 20% of the gross returns of the fund in a given year.

The main reason why hedge funds are perceived to have competitive edge over other asset classes is that they have higher degree of freedom with regard to trading strategies and investment flexibility. In many cases, they are also highly leveraged. Additionally, most funds are subject to only a modicum of regulation in the country of their registration.

In the US, which is the Mecca of hedge funds, these investment schemes are sold through private placement under the Securities Act, 1933. They cannot be offered to the general public. The US Securities Exchange Commission has capped the limit of investors in a specific hedge fund at 100. Only accredited investors can subscribe to such funds. An accredited investor is one who has a minimum networth of $1 million or a minimum income of $200,000 in each of the previous two years and there is reasonable expectation of the same level of income in the current year. Contrast these with the onerous compliance and operational requirements for mutual funds and pension funds.

The proponents of hedge funds say that hedge funds act as the second layer beyond the first level institutions, such as banks, insurance companies and pension funds. Due to their greater risk-taking ability and their freedom to structure tailor-made investment schemes, many hedge funds have been active in financing ailing companies when the first level agencies have closed their doors. Many funds are also active in the re-reinsurance business, which helps in the mitigation of risks of the insurance and reinsurance companies. There is a strong view that the capital formation process in the economy goes up as a result. Inspite of relatively higher failure rate of specific schemes, the hedge fund business is growing at more than 20% every year. Their asset under management as at the end of 2006 is $1.5 trillion Introduction of hedge funds requires a phased approach backed with adequate safeguards. First, the regulatory framework should allow Sebi and government in times of exigencies to pierce the shroud of secrecy enveloping the identity of investors. Nearly 60% of the FII investments taking place presently are through the participatory note route, where the identity of the investors is not known. The government and securities regulator should be able to get to the actual investors whenever there is suspicion of market mischief or money laundering. This leads us to the second point: hedge fund investors should be regulated entities or accredited investors in countries of their origin. Third, strict disclosure requirements should be put in place for the intermediaries and the funds, such as reporting of daily client trades, cumulative turnovers, market exposures, periodic audited statements, investor lists, etc.

This would enable the regulatory authorities to rewind and play back market transactions of any prior period. Fourth, the hedge fund route should not be allowed to become a back door mechanism for take-overs and acquisitions, for which strict compliance requirements are necessary. Lastly, the risk management systems of stock exchanges would need further tightening to prevent cascading of risks of these funds to the others.

In summary, a fine balance needs to be struck between the risk appetite and reward expectation of such investors with the social, economic and ethical objectives of the country.

The author is managing director, Inter-connected Stock Exchange of India Ltd. These are his personal views.