Market sees future in hedge funds

Date: Thursday, August 23, 2007
Author: Alok Sama

 Like many other emerging markets, India has been benefiting from significant foreign fund flows in recent years as investors’ quest for yield and increasing risk appetite has led them to look farther afield from their home markets. Hedge funds have been a less significant and undoubtedly somewhat nascent conduit thus far.

However, a combination of several factors, including continued economic strength at the macro level, increasing visibility and interest from investors and favourable developments from a regulatory standpoint, have arguably positioned hedge funds to become a far more influential and integral force in the market in the future.

The Indian equity market has several features that create an ideal playing field for hedge funds. The market comprises over 5,000 listed companies, providing an extremely broad universe of potential opportunities. At the same time, institutional ownership and research coverage is quite thin and limited to a handful of large-cap names, providing a real opportunity for hedge funds to bring its sourcing abilities and depth of research to bear on an investment.

While the current investment climate in India is undoubtedly favourable for all equity managers, hedge funds are arguably best positioned to exploit the opportunity. This can be ascribed to several factors, including the ability to invest across a wider cross-section of the investment universe (given their typically smaller size), the latitude afforded to run more concentrated portfolios (since they are typically not measuring themselves against a benchmark) and the flexibility to use tools to gain short exposure (single stock, single stock futures and index futures).

The choice of hedge funds from an investor standpoint should largely be driven by risk appetite. If an investor is looking for an option that should handily outperform the market, a hedge fund that employs a concentrated long-biased strategy would likely be appropriate. An investor in such a fund should expect significant correlation with the market and underperformance during certain periods of the market cycle.

An investor who is looking to capture a portion of the upside during market rallies, but limits the downside during market declines, should select a manager who is more trading-oriented and an active user of tools to maintain short exposure. It is true that hedge funds which have been striving to maintain an active short strategy over the past few years in India have faced an uphill battle given the strength of the bull market.

However, it is worth remembering that from 1993 to 2003, the market largely moved sideways, with the Sensex appreciating by approximately 32% during this 10-year period. It is in exactly such periods where hedge funds have the opportunity to showcase their abilities and differentiate themselves.

While the overall market performance was quite disappointing, there were plenty of underlying opportunities during this period. Granted these were primarily on the long side, given the extant restrictions on shorting stocks and limited liquidity in single stock futures.

However, a hedge fund’s ability to express a short view in India has improved markedly over the years, with a fairly liquid single stock future market available in over 100 names. In March 2007, the Securities and Exchange Board of India (SEBI) approved short selling for institutional investors in the cash segment of the Indian stock market.

 These developments are undoubtedly favourable for hedge funds, given they are afforded the flexibility to adapt to and weather different investment environments, which is critical since it is virtually guaranteed that the current one will not continue indefinitely. While the majority of hedge funds currently focused on India are equity-oriented, further strategies are expected to be employed as the market develops, liquidity improves and the cycle matures.

Certain funds have already been successfully executing ‘arbitrage’ strategies, both through cash versus futures on single stocks as well as through convertible issues. While the opportunity in non-performing loans and ‘distressed’ or ‘stressed’ debt is nascent, this area could prove an extremely fertile hunting ground for investments as banks are induced to clean up their balance sheets in an effort to attract global capital. The country’s voracious appetite for power, energy and related commodities as well as gold provides a strong underpinning for commodity-trading oriented funds.

(The author is founder & president, Baer Capital)