Usually, hedge funds:
à Are organized as private investment partnerships or offshore investment corporations;
à Use a wide variety of trading strategies involving position-taking in a range of markets;
à Employ as assortment of trading techniques and instruments, often including short-selling, derivatives and leverage;
à Pay performance fees to their managers; and
à Have an investor base comprising wealthy individuals and institutions and relatively high minimum investment limit (set at US $100,000 or higher for most funds).
Therefore, broadly speaking hedge funds including fund of funds are unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are not subject to the same regulatory requirements as mutual funds, including mutual fund requirements to provide certain periodic and standardized pricing and valuation information to investors.
References to Hedge Funds have been figuring with increasing frequency in Indian markets. While regulatory initiatives[ for hedge fund regulation in global markets are gathering momentum, in Indian markets, the impact of hedge funds has so far been felt only from a distance.
Though there are no Indian hedge funds, media reports often mention offshore hedge funds participating in Indian markets through the FII route. Globally, the hedge fund industry is supposed to have more than $1.225 trillion in assets, which is much smaller than the worldwide mutual fund assets of around $11 trillion (at the end of second quarter of 2006 as surveyed by Chicago-based Hedge Fund Research Inc.. Nearly 80% of the hedge funds assets are US-based, while Europe accounts for around 15% of the hedge fund assets. This trend of growing popularity is also evident in Asia, where hedge funds are starting to take off. According to Asia Hedge magazine, some 150 hedge funds operated in Asia, till year 2002 which together managed assets estimated at around US $ 15 billion. There are estimated to be around 6000-7000 active hedge funds at present and the industry is witnessing high growth as well as greater investor interest.
Modus operandiHedge funds do not constitute a homogeneous asset class. The bulk of hedge funds describe themselves as long / short equity, perhaps because this is the least specific of the available descriptions, but many different approaches are used taking different exposures, exploiting different market opportunities, using different techniques and different instruments:
à Global macro seeking assets that are mispriced relative to global alternatives.
à Arbitrage seeking related assets that have deviated from some anticipated relationship.
. Convertible arbitrage between a convertible bond and equity.
. Fixed income arbitrage between related bonds.
. Risk arbitrage between securities whose prices appear to imply different probabilities for an event.
. Statistical arbitrage (or ''''StatArb'''') between securities that have deviated from some statistically estimated relationship.
. Derivative arbitrage between a derivative security and the underlying security.
à Long / short equity generic term covering all hedged investment in equities.
. Short bias emphasizing or investing solely short.
. Equity market neutral maintaining a close balance between long and short positions.
à Event driven specialized in the analysis of a particular kind of event
. Distressed securities companies that are or may become bankrupt
. Regulation D distressed companies issuing securities
. Merger arbitrage - between an acquiring public company and a target public company
à Other
. Emerging markets
. Fund of hedge funds
. Quantitative
The working of hedge funds can be better understood with the help of following illustration.
The basis of most hedge fund strategies involves taking so-called long-short positions. The principle is as follows.
Suppose a hedge fund manager concludes on the basis of his analyses that company X is undervalued and company Y is overvalued. The hedge fund then sells shares in company Y, even though it does not own them: it goes short in Y. In order to fulfill its delivery obligation, the hedge fund then borrows the respective shares of Y temporarily from an institutional investor who does not need them at that time. In legal terms, this securities lending involves a transfer of the shares to (in this case) the hedge fund, with the latter being obliged to return the same number of shares of Y at a later time against payment of a loan fee. The hedge fund uses the proceeds of the sale of the shares Y to buy shares in company X: it goes long in X.
If its analysis is correct, the hedge fund gains in two ways: X is undervalued and will therefore gradually increase in value, as a result of which the value of the holding in the company also rises. The hedge fund also gains on the holding in Y. This company was overvalued and has now fallen in value, say from 100 to 80. When the hedge fund sold the shares Y, it received 100. Now it has to return the shares to the institutional investor and only has to pay 80 to buy them in the stock market. The loan fee of, say, 1 must then is deducted, so the profit on the short position is 19. The hedge fund can increase the total profit on this long-short position by contracting a loan and creating a leverage effect. A fixed rate of interest must be paid on the loan, let us say 6%. If the hedge funds analysis is correct, it will make a much higher return on the transaction, e.g. 16%. The difference between the two is the additional gain achieved through leverage. Similar effects can be achieved with certain derivatives, such as options and futures.
A typical feature of hedge funds is that they can use various investment strategies based on this type of long-short approach to detect and exploit inefficiencies in the pricing in financial markets. They are therefore interested in companies that are undervalued or overvalued. Since their activities cause such price inefficiencies to decrease or disappear, it is said that hedge funds contribute to efficient pricing in the market. After all, undervaluation simply means that demand is lagging. A long strategy causes demand to increase, thereby also leading to a rise in the price, particularly if several hedge funds are active at the same time. In the case of a short strategy, the reverse applies. The causes of the inefficient pricing on which hedge funds base their investment strategies can range from minor differences in the dual listings of companies to particular situations such as mergers or corporate distress cases.
Sebi regulations
In August 2007, SEBI decided to regulate hedge funds by asking them to register as Foreign Institutional Investors. But before going into the debate of whether this was the correct move by the market watchdog or not we need to have an overview of the relevant provisions under which such registration is proposed. It was after the SEBI (Mutual Fund) Regulations of 1996, that the asset management business under private sector took its root in India. In the same year SEBI also notified Regulations and Rules governing Portfolio Managers who pursuant to a contract or arrangement with clients, advise clients or undertake the management of portfolio of securities or funds of the client.
There is no information about any hedge funds domiciled in India. Further, on account of limited convertibility, offshore hedge funds (domiciled in Bahamas, Bermuda, The British Virgin Islands and the Cayman Island) have yet to offer their products to Indian investors within India. Although, Indian hedge funds are not known to exist, there is nothing to prevent a group of persons from pooling their resources to invest in stock markets, indulging in speculative trading and using leverage to enhance profits.
As regards foreign hedge funds operating in India, this could be done through the Foreign Institutional Investor (FII) route (through their sub-accounts) or as they have been doing through instruments like Participatory Notes (PNs).
SEBI (Foreign Institutional Investors) Regulations, 1995, regulate the funds through the FII route. Under these regulations (Regulation 2(f)), a Foreign Institutional Investor is defined as an institution established or incorporated outside India which proposes to make investment in India in securities.
Relevant Provisions of SEBI (Foreign Institutional Investors) Regulations, 1995Though hedge funds are not an excluded category of foreign institutional investors under the SEBI (FII) Regulations, 1995 they are, however, by virtue of not being regulated by securities regulators in their place of incorporation or operations, cannot come as FII under the present provisions of SEBI (FII) Regulations, 1995. Regulation 6(i)(b) of the SEBI (FII) Regulations, 1995 requires an FII applicant to be a regulated entity in its place of incorporation or operations.
The SEBI (FII) Regulations, 1995 allow sub-accounts sponsored by registered FIIs to invest in India. Regulation 2 (k) defines sub-account as follows:-
A sub-account includes foreign corporates or foreign individuals and those institutions, established or incorporated outside and those funds, or portfolios, established outside, whether incorporated or not, on whose behalf investments are proposed to be made in by a foreign institutional investor.
Further, provisions of the regulation 13 lay down the conditions and procedure for granting registration to a sub-account of an FII. Hedge Funds of almost all variations can meet the requirements of sub-accounts if they are fit and proper persons. However, based on (an internal administrative decision) if an applicant indicates in the application that it is a hedge fund, the consideration of the application is withheld. Since granting of registration to FII/sub-accounts is based on the disclosure of details and on the undertaking given by the applicant in the application form, it could be possible that a few entities who described their activities in the application form in terms other than hedge funds could have already got registration as sub-accounts. However, all sub-accounts have to be sponsored by registered FIIs who are required to be regulated entities by the relevant regulators in their home countries.
Investment limits applicable to FIIs:Chapter III of the SEBI (Foreign Institutional Investors) Regulations, 1995 inter alia lists out the instruments in which an FII/sub-account can invest. The regulation does not include currency or commodities as eligible instruments for investment for the FIIs. Therefore, currency trading or investment in commodity related financial products cannot be an option for any hedge funds under the present FII Regulations.
The SEBI (Foreign Institutional Investors) Regulations, 1995 also lays down scrip-wise and fund wise maximum limits a fund can invest. Regulation 15 (6) lays down that in respect of a Foreign Institutional Investor investing in equity shares of a company on behalf of his sub-accounts, the investment on behalf of each such sub-account shall not exceed ten percent of the total issued capital of that company.
Further, through circulars of SEBI, position limits for investment by FIIs in derivatives have been advised. These limits were advised with a view to help diversify the foreign hedge funds investments and jettison concentration in any specific scrip.
The provisions of Chapter III [Regulation 15 (3) (a) of SEBI (Foreign Institutional Investors) Regulations, 1995] disallow short selling by FIIs and stipulates that all trades by FIIs are delivery based. Clearly, existing provisions in the FII Regulations include several checks and balances which can keep the Indian market safe from potential market abuse and manipulation.
Participatory NotesSome hedge funds have invested in offshore derivative instruments issued by FIIs against underlying Indian securities. Through this route hedge funds can derive economic benefit of investing in Indian securities without directly entering the Indian market as FIIs or their sub-accounts. Almost all top FIIs, including Merrill Lynch, Morgan Stanley, Credit Lyonnais, Citigroup and Goldman Sachs, who are registered in India issue Participatory Notes. As a regulator, SEBI is worried that some of the money coming into the market routed via participatory notes could be the unaccounted wealth of some rich Indians camouflaged under the guise of foreign institutional investment. The money might even be tainted and linked with such illegal activities as smuggling, terror and drug-running.
Because of this concern, through recent amendments to the FII Regulations (Regulation 15A and 20 A), the regulatory regime has been further strengthened and periodic disclosures regime has been introduced.
Measures Taken by SEBITo regulate the participation of foreign investors through participatory notes,
à SEBI clarified that funds routed through participatory notes will be allowed to continue for a maximum period of five years from now, i.e., from January 27, 2004 or up to the expiry of the instrument, whichever is earlier
à It also made it clear that such instruments issued against underlying Indian securities on or after February 2004 can be issued only to regulated entities. Any further transfer should be in favour of regulated entities only.
à Foreign investors or non-residents are not allowed to invest directly in the Indian stock market. Their involvement in the Indian investment has to be carried out through a foreign institution, which in turn is required to register itself with SEBI.
The theory is that knowing or regulating the intermediary enables the regulator to control the underlying investor. But then, the FII, too, has no knowledge of the character of the final investor. To rectify this, SEBI directed foreign institutions as a part of the process of know-your-client (KYC) to issue participatory notes only to regulated entities. It further declared that clients who had purchased PNs were not allowed to transfer these to any other person except to those who are regulated. KYC is necessary in the interest of the efficacy of the market. Hence, with effect from 3 February, 2004 participatory notes and other derivative instruments issued against underlying Indian securities can be issued only to regulated entities.
PN Code for overseas investment firms SEBI on 19th February 2004 laid out the parameters for an overseas investment body to be considered as a regulated entity, so that it can be allotted participatory notes to invest in the domestic market. Any Entity which fulfills any one of the below mentioned requirement will be deemed to be a regulated entity:1) Any entity incorporated in a jurisdiction that requires filing of constitutional and, or, other documents with a registrar of companies or comparable regulatory agency or body, under the applicable companies legislation in that jurisdiction, will be deemed as regulated entities.
2) Entities that are regulated, authorized or supervised by a central bank, such as the Bank of England, the Federal Reserve, the Hong Kong Monetary Authority, the Monetary Authority of Singapore or any other similar body would also be considered as regulated entities
3) Entities that are regulated, authorized or supervised by a securities or futures commission, such as the Financial Services Authority (UK), the Securities and Exchange Commission (USA), the Commodities Futures Trading Commission (USA), the Securities and Futures Commission (Hong Kong and Taiwan), the Australian Securities and Investments Commission (Australia) or other securities or futures authority or commission in any country would also be considered as regulated entities.
4) Members of securities or futures exchanges such as the New York Stock Exchange (USA), London Stock Exchange (UK), Tokyo Stock Exchange (Japan), NASD (US) or any other similar self-regulatory securities or futures authority in any country, state or territory are deemed as regulated entities.
5) Lastly, any individual or entity (such as a fund, trust, collective investment scheme, investment company or limited partnership), whose investment advisory function is managed by an entity satisfying the above parameters, is eligible to invest in domestic market through PNs.
SEBI has further laid down that it is mandatory for Foreign Institutional Investors to disclose information concerning the terms of and parties to off-shore derivative instruments such as Participatory Notes, Equity Linked Notes or any other such instruments, entered into by it or its sub-accounts or affiliates relating to any securities listed or proposed to be listed in any stock exchange in India, as and when and in such form as the Board may require.
This insecurity of the regulators regarding PNs was again reflected when the Reserve Bank of India asked the Government of India to ban the issuance of participatory notes at a meeting of the government and all the regulators held earlier during this year, i.e., the year 2005. But the proposal was not accepted. Since then it has been suggested by the Reserve Bank of India that if the ban is not found to be acceptable, an option could be in the form of permitting issuance of PNs only if the identity of the final investor is fully disclosed.
The RBI is concerned over the issue of PNs because these could be misused for money laundering, besides the risk involved in permitting investment from investors who are not subject to a regulatory regime overseas or scrutiny by a regulator. The RBI is also concerned that PNs could be used to skirt the ownership norms applicable to private banks. However, a decision on the RBIs proposal is yet to be taken.
Hedge fund access to Indian marketsOn May 24, 2004, the FII Division of SEBI came out with a Press Release, wherein comments/suggestions/views from the public were invited on a report prepared by the FII Division after reviewing the developments in the hedge fund industry and studying the option of permitting hedge funds to operate within the regulatory framework of the SEBI (FII) Regulations, 1995, subject to additional safeguards. The comments on the said report have been received by the FII Division of SEBI and a decision on the same is yet to be taken.
In the said report, SEBI has acknowledged the fact that in view of the increasing popularity among the institutions as well as their increasing interest in the Indian market, it might be time to provide a limited window to this growing segment of asset management industry within the existing framework of the SEBI (Foreign Institutional Investors) Regulations. It is further stated that the approach adopted in formulating the policy suggestions put forth in the said report has been that of transparent and regulated access with abundant caution.
The suggestions given by SEBI are intended to widen the FII window to allow these alternatives investment pools to Indian securities markets in a transparent and orderly manner. In addition, the suggestions also provide for adequate safety measures to address legitimate concerns associated with these funds. SEBI has also acknowledged that the alternative investment pools, if allowed to invest in Indian markets, will be a source of additional liquidity and will also diversify the pool of foreign investments in Indian market.
Apart from the existing safety measures, as discussed above, SEBI, in the said report, has suggested some additional regulatory steps with respect to hedge funds seeking registration as FII, which are:
1. With respect to the US based Hedge Funds, the investment adviser to the hedge funds should be a regulated investment advisor under the relevant Investor Advisor Act of USA or the fund is registered under Collective Investment Fund Regulations or Investment Companies Act of USA.
2. At least 20% of the corpus of the fund should be contributed by the investors such as pension funds, university funds, charitable trusts or societies, endowments, banks and insurance companies. The presence of institutional investors in the fund is expected to ensure better governance on the part of the fund manager and fund administrators. Further, institutional investors may help fund managers to take a long-term perspective of the market.
3. The fund should be a broad based fund in terms of the SEBI (Foreign Institutional Investors) Regulations, particularly in terms of the explanation to Regulation 6(1)(d).
4. The fund manager or investment adviser must have experience of at least 3 years of managing funds with similar investment strategy that the applicant fund has adopted.
Recommendations
No panacea exists for the regulation of hedge funds. The funds themselves are out of the reach of national regulators in around the world, who must content themselves with attempting to control the fund managers. The international nature of hedge fund investment means that national regulators cannot exert total control in their own jurisdictions. The definition of hedge funds is far from clear. None of the responding jurisdictions to the International Organization of Securities Commissions. (IOSCO) survey reported a legal definition, and the features which are generally accepted to distinguish hedge funds (such as a tendency to be unregulated collective investment schemes, the extensive use of derivatives, use of shorting techniques and the use of extensive leverage) are all characteristics shared to varying degrees by other financial market players.
As time goes on hedge funds will find themselves subject to an increasing number of regulatory measures, such as Markets in Financial Instruments Directive (MiFID) and higher levels of corporate governance, that embrace other investment entities. Litigation against hedge funds is also becoming more common, and a number of actions against them claiming damages for alleged market manipulation have been brought in the past year or two by financial services firms in the United States. All these factors will all help to exert some controls over hedge funds, but at present there seems little prospect of financial regulators and institutions coming up with an effective and workable system of international hedge fund regulation in the foreseeable future much as they would like to.
As regards the situation in India SEBI has done a good job and made a smart move by letting Hedge Funds come into the growing Indian financial market, but at the same time asking them then register as FIIs. This will help them to regulate them and keep an eye on them so that another catastrophe, like which happened in 1997 would not be repeated.(The author is a student of the NALSAR University in Hyderabad.)
Source: Indlawnews