Hedge funds: Two sides to the story

Updated: Jan 19 2007, 05:30am hrs
One area where the Indian capital market has lagged behind compared to other emerging markets is the rules and regulations regarding the entry of hedge funds which are seen to be confusing. This is one area which is being closely watched by big players, both domestically and globally. Recently, a lot of heat has been generated on the topic and the subject being widely debated in various circles is whether hedge funds should be allowed or not.

A number of hedge funds which are flush with money are waiting on the sidelines to enter the Indian capital market and capitalize on the India story. At present, hedge funds are not allowed direct entry to trade in the Indian capital market as the regulatory authority Securities and Exchange Board of India (Sebi) is cautious and concerned about the origin and identity of investors behind such funds.

Interestingly, hedge funds seem to be enjoying the taste of the Indian capital market and have increased their exposure through participatory notes (PNs) issued by the foreign institutional investors (FIIs) abroad, and issues continue to be raised by the regulatory authority regarding their origin and identity.

Says an analyst with a domestic brokerage house who does not wished to be named, Hedge funds are very active in India and are an integral part of the domestic equity market now. Even the restriction prevailing on investment by hedge funds in India has not deterred them from investing. The more serious ones are entering the Indian market through the FII route or through the PN route. They come with lot of speculative capital and during a period of crisis they make a mass exodus from the market. However, during normal times, their presence will increase the overall efficiency and liquidity in the market.

What leads to the heightened criticism of hedge funds is the inherent nature associated with such funds. Hedge funds are usually lightly regulated private investment funds typically open to only a very few sophisticated and accredited investors. The investors are large institutions such as pension funds, insurance companies, private banks, universities, sovereign holding companies, high net worth individuals and families. Hedge funds employ more complex mathematical models and investment strategies using various derivative instruments intended to profit from market volatility or from a falling market.

The hedge funds which use unique strategies and high leverage in their operations sometimes cause high volatility and tend to destabilize the whole market. That is the reason why the European Central Bank (ECB) and the Securities and Exchange Commission (SEC) in the US have raised their concerns and felt the need for regulating such funds.

Growing Dominance

Hedge funds regulation is closely watched by domestic and global players
Several funds waiting on the sidelines to enter India
Sebi cautious and concerned
Hedge funds still active through FII and PN route
Almost $1.5 trillion in capital by the end of 2006
Hedge funds expanding into
arts, movies, private equity etc
Many international banks joining the fray

Many hedge funds are domiciled and have their legal residence offshore in countries unrelated either to the manager, investor or investment operations of the fund, with the objective of making tax payable only by the investor and not additionally by the fund.

Surajit Misra, senior vice president, Bajaj Capital, says, If the hedge funds are given a free hand to operate in the Indian capital market as is in the US and Europe, it will result in more volatility as they come up with huge funds and have the tendency to pull out of the market during times of crisis. They are highly profit-centred.

Some critics of the regulation theory argue that any regulation intended to curb the misuse by such funds would only slow down the process of capital formation and kill the incentives. Also, it is a source of capital for new ventures that would not otherwise get funds. They also provide immense liquidity to the market.

Adds Misra, If hedge funds are allowed to operate in the Indian equity market with certain restrictions which can hold for a long period, they can definitely widen the market base. Also India will be able to utilize the much needed foreign capital in a better way which will be a very positive sign for the market. This will result in increasing the liquidity in both the derivatives and cash segments.

Interestingly, the total capital under hedge funds has been pegged at almost $1.5 trillion at the end of 2006, which has almost doubled in three years. There are a total of 10,000 such funds out of which capital is concentrated in the top 200 funds. Some of the prominent funds which are in the reckoning (with over $ 10 billion in capital) are Bridge Water, GSAM, Citadel, SAC Capital, Renaissance, DE Shaw, Vega, Tudor etc.

Seeing the returns generated by hedge funds with a lack of regulation, many international banks are also joining the fray either by investing in hedge funds or by sponsoring their own funds.

At present, hedge funds are expanding into new assets classes like art, movies, private equity etc.