The Hindu Business Line : Hedge funds: Not the ogres as made out

THE Government proposes to allow hedge funds to invest directly in India. This may be a cause for concern to many because these funds are generally believed to destabilise the market microstructure. The much-publicised collapse of Long-Term Capital Management in 1998 still worries capital market regulators and investors world over.

But well-managed hedge funds can improve asset price efficiency in the Indian market. The proposal to allow hedge funds will not, however, amount to much unless the Securities and Exchange Board of India withdraws the ban on short-selling. This coupled with other measures that reduce price manipulation may, perhaps, enthuse hedge funds to take sizable exposure in India.

Defining hedge funds: Traditionally, these funds construct a portfolio that is market neutral. That is, the portfolio's systematic risk is almost zero. The idea is to profit from security selection with minimal exposure to broad market movements. Plain vanilla hedge funds typically use long-short strategy to achieve their objectives.

A hedge fund may, for instance, consider Hero Honda cheaper than Bajaj Auto. The portfolio manager of such a fund may buy Hero Honda and short Bajaj Auto in such a way that it is not exposed to the systematic risk but only to the price differential between the two. That is, if the portfolio were to consist of just these two stocks, its beta will be almost zero. This strategy is called pair trading.

The aggressive funds leverage their portfolio to generate bigger payoffs. The exotic hedge funds use high-level quantitative modelling for security selection. On the whole, hedge funds emphasise on security selection while mutual funds have a heavy exposure to the general market movements as well.

Improving price efficiency: Hedge funds perform a useful role in the market by aggressively constructing a portfolio of mispriced stocks. Their demand for such stocks could, therefore, pull prices towards the perceived intrinsic value. At the extreme, such funds can counter traders who manipulate asset prices in our market.

Suppose an influential trader decides to push Tata Motors from Rs 425 to, say, Rs 600. If hedge funds believe that Tata Motors is moving away from its perceived intrinsic value, they may short the stock in large quantity. Funds that follow a market-neutral strategy may combine this short position with long position in, say, Maruti Udyog. The large short positions in Tata Motors could make it difficult for traders to push prices far away from their perceived intrinsic value.

A question may arise as to why mutual funds cannot counter the price manipulators in our market. The reason is that mutual funds typically benchmark their performance. A mid-cap value fund may, for instance, benchmark its performance to the CNX Midcap Index. This prevents the fund from taking higher exposure to stocks in the index that are undervalued and lower exposure to the ones that are overvalued. If the mutual fund adopts such a strategy, its tracking error will be high. A hedge fund is not constrained by any benchmarks. Besides, these funds cater to only high net worth individuals. They, therefore, have a longer investment horizon and carry the financial strength to counter the price manipulators.

There is benefit for the derivatives market too. These funds aggressively use derivatives to construct exotic strategies. Their demand for contracts would add depth to the derivatives market, which is at present packed with day traders.

Regulatory changes: The problem is that we are aware of only those hedge funds that have lost money or caused high risk to the market microstructure. The truth is that for every failed hedge fund, there are many more that have succeeded. Of course, these funds need to be carefully monitored. Otherwise, their sheer size can cause much harm to the market microstructure.

In this context, it is heartening to note the recent measures adopted by the Securities and Exchange Commission to monitor hedge fund investments. Since hedge funds are primarily US-based, their investments in India will carefully watched by the US regulator. But that does not preclude SEBI from drafting certain mandatory rules to ensure that such funds do not destabilise our market microstructure.

Of course, SEBI has to first permit short selling. It can, perhaps, pull a leaf from SEC's book and permit short selling based on the uptick rule. Allowing short selling could be beneficial, as it may improve the long-run relationship between the spot and derivatives market. That will encourage hedging by mutual funds too.

(Feedback can be sent to bvenky@thehindu.co.in)

More Stories on : Mutual Funds | Insight | Mark To Market

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Cap the foreign investment muddle

Data belie Greenspan's optimism

Road less travelled

Hedge funds: Not the ogres as made out

Kelkar Task Force on Indirect Taxes — The difficult challenge of tax reform

Kuttambakkam

`Our challenge is to mechanise small farms'

Save yourself from heartache at petrol pumps

GTB fiasco

Boycott culture