Profiting from short-selling, or when share prices fall, is a key factor that differentiates them from traditional funds and allows them to charge much higher fees.
But India-focused hedge funds have fallen more than the country's benchmark Sensex index in nearly one-third of the 40 negative months recorded by the index since 2002, a study by the NY-based industry tracker HedgeFundNet (HFN) shows.
By comparison, Brazil and China funds have underperformed only in two and three down months, respectively, although their benchmark indices have recorded more down months than India. Russia funds have underperformed only in two down months.
The failure to deliver in down markets can hurt growth prospects and make investors question the performance fee of about 20% and management fee of 2% charged by hedge funds. Traditional funds only charge management fees.
I think the Indian hedge funds really have to re-prove themselves, said Richard Johnston, head of Asia-Pacific at hedge fund advisory firm Albourne Partners.
Grouped under the Bric moniker coined by Goldman Sachs Jim ONeill in 2001, Brazil, Russia, India and China have gained popularity in recent years as an asset class. Reliance on relatively more volatile mid-cap and small-cap stocks to generate outperformance, long portfolios and limited shorting opportunities are factors behind the underperformance of India-focused hedge funds, portfolio managers said.
Part of the reason is structural because India does not have dedicated stock lending mechanism to facilitate shorts, said Mumbai-based Vijay Krishna-Kumar, advisor to TCG IndiaStar hedge fund that has about $50 million under management.
His fund, founded by ex-Soros adviser Purnendu Chatterjee, was down 1.64% in January, compared to the 10.6% drop in Indias benchmark share index that month. Fund managers also lack experience in shorting, or betting on falling share prices.
Stylistically, Indian managers dont know how to short, Kumar said. They are usually from the mutual funds world so they don't really understand the short side very well.
India-dedicated hedge funds managed about $3.9 billion at the end of June 2010, some $5 billion short of their pre-crisis level, after losing about 50% in 2008, according to data from industry tracker AsiaHedge.
With about 5,000 listed firms and only about 650 of them covered by research analysts, according to data from Thomson Reuters StarMine, mid-caps in Asias third-biggest economy still present a fertile hunting ground for tomorrows
bluechips. However, while they have rewarded funds in a booming market and lured portfolio managers, mid-caps have also led to sharper losses in falling markets.
Even when India-focused hedge funds outperform in a down market, they lag Bric peers, said Peter Laurelli, vice president of research division at HFN. But they tend to underperform by the least amount during up months.