- SEBI and the finance ministry want to allow easy entry for hedge funds. But the RBI thinks they are risky.
- Hedge funds bring in money fast, and take it out faster. The returns are high, but so are the risks.
- Hedge funds have not invested in India directly due to too many rules
- There are moves to make the rules simpler. But critics are wary.
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It’s really quite ironical. The dictionary meaning of the word ‘hedge’ is to ‘be cautious’, ‘protect’, and ‘guard against’, among others. But instockmarket parlance, it can be either that—as in the case of futures trading—or it could be exactly its polar opposite, especially when it comes to pure ‘hedge funds’. In the latter case, the common perceptions are of fund managers who indulge in ‘speculative’ trading, influence global indices, have a very ‘short-term’ outlook, and ‘run away’ at the first hint of any crisis.
This explains why Indian policymakers and regulators are unsure about hedge funds. The stockmarket regulator, sebi, and the finance ministry want to allow easy entry for these funds by enabling them to register asFIIs (foreign institutional investors). But the Reserve Bank of India contends that short-term inflows—especially through hedge funds—can destabilise the Indian bourses and other asset categories, like real estate.
However, each time there has been a correction in the Sensex or the Nifty, the global hedge funds have been blamed for it. For, they bring in money fast, but take it away even faster. That’s because they take a risky call—on the manner in which global indices, currencies, and other asset prices will move—most times. Sometimes, they take a stand on the way economies will perform. And they believe that global asset markets are invariably imperfect and, hence, there are arbitrage opportunities to profit from.
Explains Dan Waters, head of retail policy at UK-based regulatory body Financial Services Authority(FSA), "It’s possible that a number of hedge funds cause congestion in particular strategies leading to a shock in the market." Adds Martin Wheatley,CEO, Securities and Futures Commission, Hong Kong’s regulator, "Hedge funds are more mobile than traditional funds and, unlike the latter who are tied to a benchmark, hedge funds can choose to move from one market to another rather quickly. They generally operate on a day-to-day basis." They have to because they undertake more risks.
For example, the recent crisis in the ‘yen carry trade’ was possibly due to hedge funds. Experts contend that these funds borrowed heavily in the Japanese markets because of the ‘ultra-low’ interest rates in the recent past, converted the money into dollars, and invested in several stockmarkets, including the emerging ones. This was a brilliant strategy as long as the Japanese currency remained weak. But when the yen appreciated, and the Bank of Japan hiked interest rates, there was a panic.
Hedge funds were forced to suddenly sell the stocks they were holding to get cash to repay their ‘yen’ loans. Obviously, it resulted in a major correction on almost all the global bourses, including India. In some cases, the hedge funds themselves can go bust if their predictions go wrong. Take the case of the US-based Long Term Management Fund(LTMF), a hedge fund whose capital was wiped out by the $4.6 billion losses it incurred in various assets, derivatives and indices in different geographies.
Having hired well-known scientists and mathematicians, including Nobel Prize winners,LTMF figured that the value of long-term debt bonds issued around the same time—in the US, Japan and Europe—would have to converge. It had complex mathematical models to figure out the convergence. But things went wrong in August and September 1998, when Russia defaulted on its government bonds, and manic global investors sold Japanese and European bonds to buy US Treasury bonds. The prices of all these bonds diverged, andLTMF’s strategy went totally awry.
However, market regulators across the globe are still unable to correctly define a hedge fund and come to any conclusions whether their investment philosophy or trading strategies are different from international mutual funds. Says Horst Nottmeier, director of the hedge funds division at Germany’s regulator, Bundesanstalt fur Finanzdienstleistungsaufsicht (BaFin): "You cannot generalise the investment philosophy of hedge funds regarding how fast a fund trades or how long it holds on to its invested assets. In Germany, hedge funds differ from other funds as they are allowed unlimited leverage (compared to) other funds", which are allowed to leverage up to 200 per cent.
Elaborating in a speech on ‘Are hedge funds dangerous?’ in November last year, Sweden’s central bank Sveriges Riksbank’sdeputy governor, Lars Nyberg, said, "At the end of the 1940s, US journalist Alfred Winslow Jones bought shares he considered to be undervalued and short-sold shares he considered overvalued. His idea was that the price of undervalued shares should rise relatively more on a rising market and the price of overvalued shares should fall relatively more on a falling market. This meant that the fund would earn money regardless of whether the market rose or fell—in other words the fund was protected, or hedged, against systematic market risk."
In today’s world, hedge funds are generally managed by small teams—one or two managers—and they raise money from high net-worth individuals or corporates. SaysFSA’s Waters, "The target market for hedge funds is not retail. Their investors typically include sophisticated, wealthy individuals having financial planners looking at their portfolios." These are investors who are willing to take high risks, but desire high returns. Many hedge funds give annual returns of 30 per cent and above. This is why hedge funds need to take speedy decisions and react nimbly.
Since they are forced to act fast, hedge funds don’t like to invest in markets obsessed with regulations, as it delays their trading decisions. So, while technically they are allowed to invest in Indian markets by registering themselves as fiis, they don’t do that because they don’t want to deal with market regulators or central banks either to register or to repatriate their profits. In addition,SEBI isn’t too keen to register hedge funds because of their extremely short-term mindset. Explains Abheek Barua, chief economist atABN Amro Bank: "I have worked closely with hedge funds; most of them have one or two guys running the entire show and so don’t have the time and resources to go through registration processes in different regulatory jurisdictions." That’s why hedge funds invest indirectly in India through sub-accounts ofFIIs or participatory notes (which are privately negotiated derivatives deals). Data indicates that participatory notes account for over a third of huge inflows throughFIIs.
The annual survey by International Swaps and Derivatives Association Inc among its 750 members(FIIs , banks and companies) by collating data on privately negotiated deals reveals that equity derivatives outstandings have risen from $2.4 trillion at the end of 2002 to $5.5 trillion in 2005. Most of this amount would have been negotiated with global hedge funds, although equities is just a component of these volumes. To be fair to hedge funds, it must be said that the jury is still out on their impact on global markets. The supporters think that hedge funds are integral to today’s financial markets and, in fact, they reduce global volatility. Waters is one such proponent who feels that hedge funds dissipate risk across market participants. Adds Peter Douglas, chairman,GFIA Pte, Asia’s oldest hedge fund, "Hedge funds are liquidity providers."
Regulators in the developed world too encourage direct hedge fund investments and repatriation. Says German regulator BaFin’s Nottmeier, "Since starting the first hedge funds authorisations in Germany in 2004, there have been no difficulties so far." Hong Kong’sSFC’s Wheatley is also an unworried regulator, "The hedge fund manager may operate from anywhere, but we at Hong Kong regulate their investments in Hong Kong markets."
India can take a cue from Hong Kong. Instead of allowing hedge funds to buy Indian equities through non-transparent modes like participatory notes andFII sub-accounts, SEBI should encourage them to invest openly. Agrees John Gaine, president, Managed Funds Association, a US-based group having hedge funds as members, "It’s better ifSEBI regulates them directly." And, according to Gaine, Indian finance ministry officials have told him that India will soon pass "regulations to permit hedge funds directly". Probably that’s the way to hedge against the current volatility in Indian indices.
