Hedge Funds - A Threat For Markets

Hedge funds, sometimes referred to as ‘hot money’, have gained worldwide notoriety for bringing the markets down.

Be it a crash in the currency, stock or bond market, usually a hedge fund prominently figures somewhere in the picture.

• So, what's a hedge fund?
• How is it different from a mutual fund?
• Are hedge funds good for the markets or not?
• Should they be allowed to invest in India?
We answer these hot questions and more...

Investing with an (h)edge

Hedge funds are primarily a private pool of money, or rather private funds managed by professionals. Broadly, they can be viewed as a mutual fund of a select few high-networth and high-risk investors.

Hedge versus Mutual funds

Hedge Funds

These involve a group of private investors, and minimal regulations.

A limited number of investors.

High minimum investment.

Can be highly leveraged.

Highly flexible with their investment pattern.

High fees.

Open only through private placement, usually offered to well-informed, high risk-appetite investors.

Disclosure requirements are minimal.

Mutual Funds

These involve a group of private investors, and minimal regulations.

A limited number of investors.

High minimum investment.

Can be highly leveraged.

Highly flexible with their investment pattern.

High fees.

Open only through private placement, usually offered to well-informed, high risk-appetite investors.

Disclosure requirements are minimal.

Why hedge funds...

The basic objective: Make lots of money!

Of course to generate high returns, you must also be prepared to take high risks. Hence hedge funds have been described as ‘highly aggressive’, and ones that involve many ‘complex and unconventional’ financial transactions.

They use a mix of investment options/ strategies such as short selling, arbitrage, derivatives, commodities, forex, leveraging, etc.

In fact, contrary to the conventional meaning of the term ‘hedge’ which means ‘to protect’, these funds take a much higher risk than conventional mutual funds.

Living on the hedge!

Hedge funds don’t really enjoy a good reputation in the financial markets.

Reason 1: There's a shroud of secrecy surrounding their investments. Their financial dealings are not required to be disclosed. This helps in keeping their trading strategies a secret, and little information is available in the public domain about their operations.

Reason 2: Hedge funds make the markets highly volatile, since the strategies usually involve huge money movement in the markets in a very short span of time.

Hence, they cause huge swings in the market (both on the upside and downside), thus meriting the term ‘hot money’.

The highs and the lows

A host of such sharp volatilities in various markets have been due to these hedge funds. These tend to destabilise the markets, and can result in huge losses for long-term investors in such markets, who are not as nimble as the hedge funds.

Some, however, believe that hedge funds provide liquidity and momentum to the markets, and hence are good for the markets. In fact, sometimes they create markets for illiquid instruments, and thus help other investors too. Also, they take more contrarian calls than the large established institutional investors, and hence make the markets broader and more dynamic.

But given that little is known about the operational strategies of the hedge funds, it is difficult to categorically say whether they are actually good or bad for the markets.

And so, the debate continues as to whether these funds need strict regulations, even in the USA, where such funds have been operational for many years now.

On Indian turf
While they mean big business in the US, hedge funds are relatively unknown in India, and foreign hedge funds, so far, have not been allowed to invest in India.

But it is widely believed that they may already be operating in India through the Foreign Institutional Investors (FIIs).

Hence, it is difficult to assess the exact extent of the presence of foreign hedge funds in the country. Moreover, since the Indian markets are already aligning with the global markets, the entry of hedge funds is more a question of ‘when’ and not ‘whether’.

The registration of such funds, like the FIIs, would also be in line with the ‘know your client’ norm. This will at least bring in more transparency to their operations in the Indian markets.

No pain, no gain

It's true that volatility may occasionally cause a lot of pain. But one can gain some comfort from the fact that the global financial markets have admirably stood firm with many such shocks in the past, and some have come out stronger.

While, volatility cannot be wished away (in fact some volatility is good for the markets), one can have proper systems and procedures in place so as to safeguard the markets.
Moreover, the systems and procedures, at least in the Indian equity markets are robust and world class.

The last word

The Indian economy is on a pretty solid wicket. Therefore, the entry of hedge funds can only add more to the markets, rather than take away from it.

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