Hedge Funds

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With the Indian economy growing at 9% and the inbuilt sound stability in the financial system, investors from foreign shores are queuing to be a part of the Indian success story. Hedge funds are no exception and they are estimated to be investing in large amounts through the Foreign Institutional Investments route. The regulators like RBI and SEBI have taken a precautionary and watchful stand to the entry of these high leverage players which are known to add excessive volatility in the market. Thus far the participation of hedge funds has been fairly limited, largely because of the SEBI requirement to be registered for the use of Participatory-notes and the ceiling on the investment through the FII route

The paper starts off with a general tour on Hedge funds, the investment strategies employed by them, points of disparity with Mutual Funds, their emergence in India, the hedge funds functional in the country and the Impact on the Indian Capital Market. The study will highlight the strategies employed by the hedge funds, how they can be useful in the Indian context and what India needs to guard against.

The presentation tries to analyze the pros and cons of operation of hedge funds in the Indian capital markets and its associated effects on the economy as a whole. Also the analysis includes role of hedge funds in past historical events like Long Term Capital Management, Asian Crisis, Black Monday, so that we get a better idea about the importance and criticalities of hedge funds to function in an efficient manner.

Finally, after analyzing the pros and cons of participation of hedge funds in the Indian capital markets a conclusion is drawn about their likely impact.

Hedge funds have grown quickly globally over the past 10 years from 610 in 1990 up to almost 10,000 today. At the start of 2007, estimates suggest that hedge funds have assets of over US$1.4 trillion under their management. With general leverage levels of four to five -this means that hedge funds are active speculators with US$6 - 10 trillion at their disposal. In addition to that the rapid and aggressive trading style that they employ, and their impact is even higher than the level of assets under their management would suggest. The bulk of hedge fund activity is in the US, the UK, the rest of Europe and Asia-Pacific, although for tax purposes, the majority of hedge funds are domiciled in offshore tax havens.

Why bother with an industry which accounts for only 3-4% of the assets in global financial markets? This is based on estimates that hedge funds make up 10% of market trade volumes and in this industry participants are able to generate market-uncorrelated performance.

The term hedge fund is misleading in that a hedge fund does not necessarily have to hedge. Over time, the activities of hedge funds broadened into other financial instruments and activities. Hedge funds are private and unregistered investment pools. All the partner's capital amounts are pooled together for the purpose of trading in securities. All hedge funds follow some sort of trading strategy and are pretty much free to use any financial instrument.

Hedge funds are characterized by the use of alternative management styles or investment strategies. Based on investment strategy, the hedge fund industry can be divided into the following categories:

 Long/Short Equity Hedge funds -

 Global,

 Sector specialists,

 Country or Geographical Area specialists

 Relative Value -

 Convertible Bond arbitrage,

 Fixed Income arbitrage,

 Equity Market neutral, MBS arbitrage

 Directional/Trading -

 Global Macro,

 Managed Futures,

 Short sellers

 Other Strategies -

 Holding Company,

 Arbitrage,

 Volatility trading,

 Real estate,

 Natural events,

 Lending

Classifying Hedge Funds by Risk:

More Risk: These strategies seek higher returns, they often use leverage, typically invest in unanticipated events.

Moderate Risk: Traditional Long/short strategy with portion of portfolio hedged.

Risk Averse: These funds emphasize consistent, but moderate returns.

All hedge funds operate on two basic strategies:

 Absolute Return

 Benchmark Tracking

In the absolute return strategy the hedge fund assures a fixed return irrespective of the performance of the capital markets. This rate would be ideally slightly higher than the rate offered by government securities. Whereas in benchmark tracking strategy the hedge fund promises to give a return that tracks the benchmark index and offers a slight cushion over and above the market return. Hedge funds mostly work on the absolute return strategy.

Parameters of judging:

Mutual Funds Hedge Funds

Expected Returns- 1. Boom 2. Crash Good Returns Low or negative returns Decent