The enigma of hedge funds

There is a sense of shock and awe amongst most participants in the Indian markets whenever they refer to hedge funds. What is it that gives these funds such an aura?

Just as the seemingly omnipotent 'foreign hand' has been blamed whenever a national disaster strikes, hedge funds come into the limelight whenever the markets go into an overdrive, either upward or downward.

It is widely believed in market circles that hedge funds played a significant role in the phenomenal rise of the BSE Sensex in December 2003 and on Black Monday in May 2004. One expects the ongoing Sebi enquiry to throw some light in this regard.

In any case, the advent of hedge funds in the Indian market can be viewed as a sign of the domestic market's realignment with the global market.

During the second half of 2003, emerging markets, including India, were the favourite destination for hedge funds. These funds also delivered much higher returns on emerging market portfolios compared to the returns on their average global portfolio.

However, they were also charged with playing a role in the 1997-98 Asian crisis. It is believed that their forward sales of the Thai baht occurred well after Thai firms and global banks had bet that the baht would collapse. But the eventual spread of the malaise to other currencies like the Indonesian rupiah caught hedge funds unawares.

Having learnt their lesson, some of the developing countries drafted stringent policy guidelines. In 1998, the Malaysian government came up with a guideline that required portfolio investment funds to remain in the country for a year.

Another fact that must be taken into account is the likely impact these funds will have on other institutional investors in the market. With the entry of these fast-moving funds into the market, other institutional players might be forced to realign their investment style to a shorter duration.

They might be constrained to keep booking profits regularly due to the fear of a sudden sell-off by hedge funds. This, in turn, will boost speculative trading.

Furthermore, in order to match the very high returns generated by these funds some of the institutional players may adopt a high risk-high reward strategy. The worry here is that they may not yet have adequate expertise and experience compared to hedge funds.

In India, a common opinion is that hedge funds might bring in too much volatility in the market. Due to globalisation and economic liberalisation, many developing countries have experienced financial turbulence caused by the operations of such big market players. Hedge funds have been able to cause swings in values and prices of currencies, stocks and interest rates.

The real worry of regulators the world over regarding hedge funds has been that they tend to increase market volatility. And, occasionally, they have caused entire economies to crack under the weight of their selling.

It is believed that one fifth of the huge FII investments witnessed in the Indian capital market last year was 'hot money' (read hedge funds). This might have contributed to the phenomenal rise in domestic indices between March 2003 and December 2003 and the unprecedented fall on Black Monday.

In short, hedge funds are a double-edged sword as they are momentum players who escalate the possibility of a financial crisis.

However, one of the pluses of hedge funds is that they provide a lot of liquidity to the market, and thus enhance the price discovery mechanism at the bourses. While their operations do result in unlocking the potential value of stocks, it is normally only in the short term.

On the flip side, they also cause steep dips in prices, whenever they exit the markets, shaking sentiment badly. Also, the activities, modus operandi and even the identities of these players are kept a secret.

So, is there any advantage in allowing hedge funds to participate in the Indian stock market? In an open market system like ours one can't wish away hedge funds. They have an appointed role in a free market. A section of analysts also points to the revenue potential these funds hold out to the illogical, lop-sided and perpetually cash-strapped Indian tax system.

Because hedge fund managers buy and sell so frequently, investors incur high capital gains, which are normally taxed at the maximum marginal income tax rate. Hedge fund managers disregard benchmarks. Instead, they aim for absolute returns - in most cases a certain percentage return, year in and year out, regardless of how well the market does.

Also, since hedge funds do not track the market on a pin-point basis and undertake high-speed entries and exits, they guard the investor's portfolio from the vagaries of market trends.

At the same time, as several successful hedge funds have demonstrated, they can also generate very high returns. A prime example is the multi-billion-dollar Quantum Fund managed by George Soros.

While one may need to realign one's investment strategy to take cognisance of the presence of hedge funds in the market, the bottomline is that there is no escaping them.

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