It's not difficult to fathom why SEBI chairman M Damodaran is hell-bent on getting guidelines in place to regulate - at least partially - hedge funds in India.

Total assets in hedge funds investing primarily in India's markets have risen 400 per cent to $13.97 billion as of July-end 2007 from $2.8 billion at the end of the third quarter of 2005, said HedgeFund.Net, a firm that tracks hedge fund investments.

Since over 90 per cent of such funds invest in Indian equity, that's almost one-fourth of the net cumulative investments by foreign institutional investors into the asset class during the period.

The interest in India is not without its reasons: "Hedge funds investing in India trail only China as the best performing region or country of investment focus," says the report.

This is in stark contrast to 2001-2002, when returns in India lagged those of other emerging markets, especially on account of mistrust in India's markets due to the various stock market scams and the bust-up of US-64, the investment scheme of what was then the Unit Trust of India.

In 2001, the average annual returns of the entire hedge fund space tracked by HedgeFund.Net was 11.42 per cent, while that of India-focused funds was a negative 44.12 per cent.

At that time, funds investing in eastern European markets had the best cumulative returns, according to the report.

But things have definitely changed, with the average performance of India-focused hedge funds being higher than the performance of the entire universe of hedge funds over the past five-and-a-half years.

Even in the three months up to July 2007, when all global markets have suffered on account of the sub-prime defaults in the US, India-focused funds managed a return of 12.33 per cent, higher than the 3.31 per cent for the hedge fund aggregate average.

In the last twelve months through July, the average return for India-focused funds is 53.63 per cent, while the Sensex has returned 44.74 per cent.

But this phenomenon of India-focused hedge funds beating the benchmark, is fairly recent.

"In 2005 and 2006, the average India fund returned 21 per cent and 27.86 per cent, while the Sensex returned 42.33 per cent and 46.70 per cent, respectively," said the report.

Since 2001, the average annual compound return for these funds is 18.44 per cent, while the Sensex return is 23.04 per cent.

But what may be of concern to hedge fund managers another aspect: that the correlation between Sensex returns and those of the India-focused hedge funds is narrowing. In the last 12 months, this correlation was 0.92 - meaning that hedge fund returns almost mirror that of the Sensex.

So if this correlation increases further, then the regulator may not have to interfere at all. If they can't beat the benchmark, then the flows could even out on their own, and find their resting place in other markets.