Governments and regulators worldwide are acknowledging the need for hedge funds to impart liquidity and refine the pricing system in stock markets. But guidelines on their marketing will need to be drawn up carefully, so that investors are adequately appraised of the associated risks.

Lokeshwarri S.K.

The RBI's monetary policy for 2007-2008 has helped bring hedge funds within reach of the Indian market. Till now, hedge funds have been hesitant to register directly with the Indian stock market regulator, preferring to invest in India through FII sub-accounts.

Though the Securities and Exchange Board of India (SEBI) has laid down the guidelines for the direct registration of hedge funds, the latter have not yet come forward to do so.

The alternative investment industry has also not thus far shown any interest in tapping the Indian investors for raising funds.

The money infused in the Indian stock market by the hedge funds has been raised overseas, in the US, Europe and elsewhere.

But the changes made in the recent Monetary Policy of April 24 might alter the mindset of hedge funds regarding the fund-raising potential in India.

The RBI, in a bid to usher in greater capital and current account convertibility of the rupee, has increased the present limit for individuals for any permitted current or capital account transaction from $50,000 to $100,000 per financial year.

The restriction of capital convertibility to $50,000 was one of the reasons why hedge funds were not interested in marketing their products in India.

The SEBI report on hedge funds states: "As long as there will be restriction on capital account convertibility, foreign hedge funds, by virtue of their investment limit being $1,00,000 or higher, do not seem to be excited to access investment from Indian investors in India."

Decreasing Threshold

Hedge funds typically restrict the number of investors to below 100 or confine membership to qualified purchasers who are high-net-worth individuals with investments above $5 million.

The minimum investment in a hedge fund was, therefore, high, at $1 million and above.

The drive to raise more capital and to expand the assets under management is driving hedge funds to decrease the minimum investment to $200,000, or even $100,000.

Another way hedge funds have been made accessible to retail investors is through the launch of mutual funds that invest in hedge funds. These funds of funds are listed and traded on stock exchanges and are subject to regulations.

Investors with a lower investment threshold, seeking an exposure in these instruments find them a viable option.

We have come a long way from the time when hedge funds were eyed warily.

Governments and regulators across the globe are acknowledging the need for these funds to impart liquidity and to refine the pricing system in stock markets.

Why Hedge Funds

These instruments are gaining popularity, not only among aggressive investors but also among the more conservative lot, such as pension funds, charitable institutions, university trusts, and so on, that are taking advantage of the tax benefits offered by offshore hedge funds to diversify their portfolios and enhance returns.

Hedge funds have many features that differentiate them from other investment avenues.

They seek absolute returns and not relative returns, such as those sought by mutual funds.

That is, they do not benchmark their performance with any equity index, so that the return generated is not correlated with the equity market.

That makes them ideal instruments for diversifying risk. Many hedge funds hedge their purchases by selling options to protect the capital in adverse market conditions.

The managers of these funds typically own a significant portion of the fund, apart from charging management fees and performance fees that are related to the fund's performance. This ensures that the assets under management will be put to optimal use.

Though many of the hedge funds do take a call on the market direction and take positions accordingly, it would be unfair to say they cause market volatility.

Need for regulatory framework

It is, of course, understood that investment in hedge funds should only be undertaken by `sophisticated' investors with deep pockets.

The US Companies Act restricts individuals based on their net worth and monthly income from investing in these instruments.

Plenty of groundwork needs to be done before hedge funds are marketed freely in India.

SEBI will need to formulate detailed guidelines, paying particular attention to the marketing of these products to ensure that investors are adequately appraised of the associated risks.

Valuation of assets held by these funds and mandating periodic disclosures to investors and the regulator are other areas that will need to be addressed.

(This article was published in the Business Line print edition dated May 6, 2007)
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