Hedge Funds

CHAPTER I: INTRODUCTION

The term 'hedge fund' is used to describe a wide variety of institutional investors

employing a diverse set of investment strategies. Although there is no formal

definition of 'hedge fund,' hedge funds are largely defined by what they are not and by

the regulations to which they are not subject. As a general matter, the term 'hedge

fund' refers to unregistered, private investment partnerships for wealthy sophisticated

investors (both natural persons and institutions) that use some form of leverage to

carry out their investment strategies.

The term 'hedge fund' is undefined, including in the federal securities laws. Indeed,

there is no commonly accepted universal meaning. As hedge funds have gained

stature and prominence, though, 'hedge fund' has developed into a catch-all

classification for many unregistered privately managed pools of capital. These pools

of capital may or may not utilize the sophisticated hedging and arbitrage strategies

that traditional hedge funds employ, and many appear to engage in relatively simple

equity strategies. Basically, many 'hedge funds' are not actually hedged, and the term

has become a misnomer in many cases.

Hedge funds engage in a variety of investment activities. They cater to sophisticated

investors and are not subject to the regulations that apply to mutual funds geared

toward the general public. Fund managers are compensated on the basis of

performance rather than as a fixed percentage of assets. 'Performance funds' would be

a more accurate description.

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CHAPTER II

Objective of the study:

To understand the meaning & characteristics of Hedge Funds

To understand the growth & future prospects of Hedge Funds

To understand the working of a Hedge Funds

To know the benefits of Hedge Funds

To understand the risk faced by Hedge Fund Investments & Managers

To understand the future prospects of this industry in India

Research methodology:

In order to accomplish this project successfully we will take following steps.

Data collection:

Secondary Data:

Internet, Books, newspapers, journals and books, other reports and projects, literatures

Limitations of research:

The study is limited to understanding the working of the hedge fund Industry & its

future prospects in India

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CHAPTER III: CHARACTERISTICS OF HEDGE FUNDS

Hedge funds utilize a variety of financial instruments to reduce risk, enhance

returns and minimize the correlation with equity and bond markets. Many

hedge funds are flexible in their investment options (can use short selling,

leverage, derivatives such as puts, calls, options, futures, etc.).

Hedge funds vary enormously in terms of investment returns, volatility and

risk. Many, but not all, hedge fund strategies tend to hedge against downturns

in the markets being traded.

Many hedge funds have the ability to deliver non-market correlated returns.

Many hedge funds have as an objective consistency of returns and capital

preservation rather than magnitude of returns.

Most hedge funds are managed by experienced investment professionals who

are generally disciplined and diligent.

Pension funds, endowments, insurance companies, private banks and high net

worth individuals and families invest in hedge funds to minimize overall

portfolio volatility and enhance returns.

Most hedge fund managers are highly specialized and trade only within their

area of expertise and competitive advantage.

Hedge funds benefit by heavily weighting hedge fund managers’ remuneration

towards performance incentives, thus attracting the best brains in the

investment business. In addition, hedge fund managers usually have their own

money invested in their fund.

Facts about the Hedge Fund Industry

Estimated to be a $1 trillion industry and growing at about 20% per year with

approximately 8350 active hedge funds.

Includes a variety of investment strategies, some of which use leverage and

derivatives while others are more conservative and employ little or no leverage.

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Many hedge fund strategies seek to reduce market risk specifically by shorting

equities or through the use of derivatives.

Most hedge funds are highly specialized, relying on the specific expertise of

the manager or management team.

Performance of many hedge fund strategies, particularly relative value

strategies, is not dependent on the direction of the bond or equity markets --

unlike conventional equity or mutual funds (unit trusts), which are generally

100% exposed to market risk.

Many hedge fund strategies, particularly arbitrage strategies, are limited as to

how much capital they can successfully employ before returns diminish. As a

result, many successful hedge fund managers limit the amount of capital they

will accept.

Hedge fund managers are generally highly professional, disciplined and

diligent.

Their returns over a sustained period of time have outperformed standard

equity and bond indexes with less volatility and less risk of loss than equities.

Beyond the averages, there are some truly outstanding performers.

Investing in hedge funds tends to be favored by more sophisticated investors,

including many Swiss and other private banks that have lived through, and

understand the consequences of, major stock market corrections.

An increasing number of endowments and pension funds allocate assets to

hedge funds.

CHAPTER IV: GROWTH OF HEDGE FUNDS

In the entire financial services area, the sector showing the most growth is clearly the

area of hedge funds. While brokerage commissions continue to decline, investment

banking fees start to come under pressure and the entire financial services industry

worries about intensified regulatory scrutiny, the hedge fund industry with its rapid

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growth stands out from the crowd. New funds are starting up every week and many

are beginning with an excess of a billion dollars under management from day one. The

amount of money under management with hedge funds has gone up four times

between 1996 and 2004 and is expected to further triple between now and 2010 to

over $2.7 trillion. Public funds, endowments, and corporate sponsors have all

increased their allocations to hedge funds within the context of an increased allocation

towards alternative investments more generally. This move towards increased

investments in real estate/private equity/hedge funds (alternative investments) is

driven by the need for a higher return to compensate for the expected lower returns

from more conventional investment strategies focused on US bonds and equities.

There is also a clear desire among this investor base to be more focused on absolute-

return strategies rather than relative return. Given the current level of allocations most

of these large long-term investors have towards alternative investments, and their

professed long-term target allocation, the flow of funds to these asset classes will

remain strong.

One of the intriguing developments in the hedge fund world is the clear desire

and ability of the newer funds to charge higher fees and impose more stringent terms

on investors. No longer are funds charging a 1 per cent management fee and 20 per

cent of profits -- the norm for the first generation of funds set up in the early to mid

1990s. As per an interesting study done by Morgan Stanley's prime brokerage unit,

about a third of the funds opening in the past six months are charging a 2 per cent

management fee and 20 per cent of profits or higher, while the majority are charging a

1.5 per cent management fee and 20 per cent of profits. Many of the new funds have

more stringent lock-ups and stiff penalties if you redeem early, as well as modified

high-water marks.

The hedge fund business thus seems to have the unique characteristic of being

possibly the only business that I know of wherein new players (most of whom are

unproven) have the ability to charge more and get better terms than the established

operators. This implies a negative franchise value for the established large fund

complexes which have survived and prospered through the years. Given that most of

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the best hedge fund complexes are closed to new investors, the new guys seem to be

taking advantage of the huge demand-supply mismatch for quality money managers.

There is a feeding frenzy currently under way in the world of alternative investments

and clients are paying up the higher fees for fear of being locked out from these funds

at a later date, if they actually survive and grow.

One reason why the new boys are focusing more on fees and lock-ups could be the

difficulty all hedge funds are having in generating adequate alpha (excess return) to

ensure an adequate payout for themselves.

In a study done by Morgan Stanley on the excess returns generated by hedge

funds over the last decade, this trend of declining returns was very apparent. In the

study they defined excess returns as the return of the Hedge Fund research composite

over one month LIBOR (a proxy for cash returns).

In the 1995-97 period, excess returns were 14 per cent; these returns have

consistently declined dropping to as low as 5 per cent in 2001-03 and have dropped

further since.

The current huge inflows into funds focused on emerging markets make sense if

you look at performance numbers over the past three years.

Hedge funds focused on the emerging markets had the best returns with an 18

per cent annual return during 2001-04, closely followed by distressed debt focused

funds at 17 per cent. More conventional hedge fund strategies of tech at 0 per cent and

risk arbitrage at 3 per cent annual return lagged far behind. Given the constant inflows

into new hedge funds, clients do not yet seem to be bothered about paying higher and

higher fees for lower returns, but this is a discussion that I am sure will come up at

some stage in most investment committees. At some stage if the hedge fund

community continues to show declining alpha (excess returns), clients will need to

question whether the proliferation of hedges has reduced returns because the field has

become too competitive.

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The beauty of the hedge fund business and the reason why the upward drift in

fee structure is even more surprising is the ease of entry of new players into the game.

The average long short hedge fund needs only about six back office staff per billion

dollars, while a global macro fund needs about 11 people for a fund of similar size

(Morgan Stanley survey). The typical long short US equity manager has only nine

investment professionals and three in the back office. These funds are also not really

regulated and have very limited disclosure requirements, if any. The start-up costs of

these vehicles are also minimal and most funds will be able to break even at sub $100

million in assets under management. There is no other industry that I am aware of

where exit and entry are as simple.

Hedge funds till date in 2005 have had a tough year; there have been few strong trends

to capitalize on and most funds are struggling to show a positive return. If the hedge

fund industry ends the year flat or even (god forbid) negative after disappointing

relative performance in 2003 and just about average numbers in 2004, some of the

more sophisticated clients may migrate back to more conventional forms of investing

with lower fee structures. Hedge funds are clearly here to stay, and continue to attract

the best talent because of their payout structures; however, their ability to continue to

command a premium fee structure will eventually be limited by their ability to

differentiate themselves from their long-only brethren on the performance front.

CHAPTER V: HEDGE FUND DATA

Why hedge funds are attractive?

There are a large number of investment vehicles that offer you good and stable

returns. Products like diversified mutual funds, blue chip stocks and property are some

of them. But for high net worth individuals (HNIs), there are more routes, especially

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in the international markets. Here we look at one such vehicle, namely hedge funds. A

hedge fund is a common term used to describe private unregistered investment

partnerships. Since most of them are not registered with financial regulators in their

countries of origin, they do not need to meet the eligibility requirements to register as

institutional investors. This is good in a way but could turn sour as well because there

are no guidelines binding them...

These funds are very manager-centric as the entire onus of their success or failure falls

on the fund manager's ability to exploit existing market conditions. No wonder then

that they charge a fixed fee of around 2 per cent a year of assets under management,

along with a very high profit sharing percentage, which is mostly 20 per cent. Of

course, they have to assure returns as well. Thus, profit sharing may start on the

returns over and above say, the first 10 per cent returns. The fee is also based on a

high watermarking concept, which means that the fund manager is entitled to a share

of profits the first time. Thereafter, if the fund incurs losses and then recoups, the fund

manager will not be entitled to any share of the recouped losses. The next time he will

be entitled is when he beats his earlier performance.

However, given the plethora of opportunities worldwide, the fund manager has the

luxury of making investment decisions in stocks, bonds, commodities, currencies etc.

The basic idea is to generate aggressive returns. The most important feature of hedge

funds is that they seek to deliver absolute, rather than benchmarked returns. For

example, equity mutual funds are benchmarked against an index like the Nifty or BSE

200, or a banking sector mutual fund could benchmark its returns against the banking

index on a stock exchange and can show the investors how much better/worse he has

performed. However, hedge funds managers do not have any such luxuries.

Since they are not regulated, most countries do not allow them to raise money from

the general public through a prospectus or advertisements. A few are registered with

the regulators in their countries because their main investors are universities, pension

funds and insurance companies.

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Most of the marketing is done through investment advisors or personal contacts, with

their main investors being restricted to sophisticated HNIs.  With the Reserve Bank of

India (RBI) allowing Indian residents to invest up to $200,000 abroad per head a year,

it is another opportunity for HNIs to tap these funds as the minimum limit of many of

them start from $100,000. But you need to remember that the amount invested is not

very liquid and may be subject to a lock-in period, with quarterly, half-yearly or

yearly exit windows.

Those seeking to invest in hedge funds can approach a wealth manager, securities

broker or investment consultant abroad, who can advise them on the available options

and select the hedge fund they wish to invest in, based on its track record and

management style. After that they can approach their bank in India to arrange for the

foreign remittance to the hedge fund. Whenever they wish to redeem their investment,

as permitted by the hedge fund, they can repatriate the proceeds to India into their

bank account.

What information should one seek if one is considering investing in a hedge fund

or a fund of hedge funds?

Read a fund's prospectus or offering memorandum and related materials.

Make sure you understand the level of risk involved in the fund's investment

strategies and ensure that they are suitable to your personal investing goals,

time horizons, and risk tolerance. As with any investment, the higher the

potential returns, the higher the risks one must assume. 

Understand how a fund's assets are valued. Funds of hedge funds and hedge

funds may invest in highly illiquid securities that may be difficult to value.

Moreover, many hedge funds give themselves significant discretion in valuing

securities. One should understand a fund's valuation process and know the

extent to which a fund's securities are valued by independent sources. 

Ask questions about fees. Fees impact your return on investment. Hedge

funds typically charge an asset management fee of 1-2% of assets, plus a

“performance fee” of 20% of a hedge fund’s profit. A performance fee could

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motivate a hedge fund manager to take greater risks in the hope of generating a

larger return. Funds of hedge funds typically charge a fee for managing your

assets, and some may also include a performance fee based on profits. These

fees are charged in addition to any fees paid to the underlying hedge funds.

Understand any limitations on your right to redeem your shares. Hedge

funds typically limit opportunities to redeem, or cash in, your shares (e.g., to

four times a year), and often impose a "lock-up" period of one year or more,

during which you cannot cash in your shares. 

Research the backgrounds of hedge fund managers. Know with whom you

are investing. Make sure hedge fund managers are qualified to manage your

money, and find out whether they have a disciplinary history within the

securities industry. One can get this information (and more) by reviewing the

adviser’s Form ADV. You can search for and view a firm’s Form ADV using

the SEC’s Investment Adviser Public Disclosure (IAPD) website. You also can

get copies of Form ADV for individual advisers and firms from the investment

adviser, the SEC’s Public Reference Room, or (for advisers with less than $25

million in assets under management) the state securities regulator where the

adviser's principal place of business is located. If you don’t find the investment

adviser firm in the SEC’s IAPD database, be sure to call your state securities

regulator or search the NASD's Broker Check database for any information

they may have.

Don't be afraid to ask questions. You are entrusting your money to someone

else. You should know where your money is going, who is managing it, how it

is being invested, how you can get it back, what protections are placed on your

investment and what your rights are as an investor. In addition, you may wish

to read NASD’s investor alert, which describes some of the high costs and risks

of investing in funds of hedge funds.

What protections does one have if one purchases a hedge fund?

Hedge fund investors do not receive all of the federal and state law protections that

commonly apply to most registered investments. For example, you won't get the same

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level of disclosures from a hedge fund that you'll get from registered investments.

Without the disclosures that the securities laws require for most registered

investments, it can be quite difficult to verify representations you may receive from a

hedge fund. You should also be aware that, while the SEC may conduct examinations

of any hedge fund manager that is registered as an investment adviser under the

Investment Advisers Act, the SEC and other securities regulators generally have

limited ability to check routinely on hedge fund activities.

The SEC can take action against a hedge fund that defrauds investors, and we have

brought a number of fraud cases involving hedge funds. Commonly in these cases,

hedge fund advisers misrepresented their experience and the fund's track record. Other

cases were classic "Ponzi schemes," where early investors were paid off to make the

scheme look legitimate. In some of the cases we have brought, the hedge funds sent

phony account statements to investors to camouflage the fact that their money had

been stolen. That's why it is extremely important to thoroughly check out every aspect

of any hedge fund you might consider as an investment.

Hedging Strategies

Wide ranges of hedging strategies are available to hedge funds. For example:

Selling short - selling shares without owning them, hoping to buy them back at

a future date at a lower price in the expectation that their price will drop.

Using arbitrage - seeking to exploit pricing inefficiencies between related

securities - for example, can be long convertible bonds and short the underlying

issuer’s equity.

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Trading options or derivatives - contracts whose values are based on the

performance of any underlying financial asset, index or other investment.

Investing in anticipation of a specific event - merger transaction, hostile

takeover, spin-off, exiting of bankruptcy proceedings, etc.

Investing in deeply discounted securities - of companies about to enter or exit

financial distress or bankruptcy, often below liquidation value.

Many of the strategies used by hedge funds benefit from being non-correlated

to the direction of equity markets

Popular Misconception

The popular misconception is that all hedge funds are volatile -- that they all use

global macro strategies and place large directional bets on stocks, currencies, bonds,

commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge

funds are global macro funds. Most hedge funds use derivatives only for hedging or

don't use derivatives at all, and many use no leverage.

CHAPTER VI: BENEFITS OF HEDGE FUNDS

Many hedge fund strategies have the ability to generate positive returns in both

rising and falling equity and bond markets.

Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk

and volatility and increases returns.

Huge variety of hedge fund investment styles – many uncorrelated with each

other – provides investors with a wide choice of hedge fund strategies to meet

their investment objectives.

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Academic research proves hedge funds have higher returns and lower overall

risk than traditional investment funds.

Hedge funds provide an ideal long-term investment solution, eliminating the

need to correctly time entry and exit from markets.

Adding hedge funds to an investment portfolio provides diversification not

otherwise available in traditional investing.

Hedge Fund Styles

The predictability of future results shows a strong correlation with the volatility of

each strategy. Future performance of strategies with high volatility is far less

predictable than future performance from strategies experiencing low or moderate

volatility.

Aggressive Growth: Invests in equities expected to experience acceleration in growth

of earnings per share. Generally high P/E ratios, low or no dividends; often smaller

and micro-cap stocks which are expected to experience rapid growth. Includes sector

specialist funds such as technology, banking, or biotechnology. Hedges by shorting

equities where earnings disappointment is expected or by shorting stock indexes.

Tends to be "long-biased." Expected Volatility: High

Distressed Securities: Buys equity, debt, or trade claims at deep discounts of

companies in or facing bankruptcy or reorganization. Profits from the market's lack of

understanding of the true value of the deeply discounted securities and because the

majority of institutional investors cannot own below investment grade securities. (This

selling pressure creates the deep discount.) Results generally not dependent on the

direction of the markets. Expected Volatility: Low - Moderate

Emerging Markets: Invests in equity or debt of emerging (less mature) markets that

tend to have higher inflation and volatile growth. Short selling is not permitted in

many emerging markets, and, therefore, effective hedging is often not available.

Expected Volatility: Very High

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Funds of Hedge Funds: Mix and match hedge funds and other pooled investment

vehicles. This blending of different strategies and asset classes aims to provide a more

stable long-term investment return than any of the individual funds. Returns, risk, and

volatility can be controlled by the mix of underlying strategies and funds. Capital

preservation is generally an important consideration. Volatility depends on the mix

and ratio of strategies employed. Expected Volatility: Low - Moderate - High

Income: Invests with primary focus on yield or current income rather than solely on

capital gains. May utilize leverage to buy bonds and sometimes fixed income

derivatives in order to profit from principal appreciation and interest income.

Expected Volatility: Low

Macro: Aims to profit from changes in global economies, typically brought about by

shifts in government policy that impact interest rates, in turn affecting currency, stock,

and bond markets. Participates in all major markets -- equities, bonds, currencies and

commodities -- though not always at the same time. Uses leverage and derivatives to

accentuate the impact of market moves. Utilizes hedging, but the leveraged directional

investments tend to make the largest impact on performance. Expected Volatility:

Very High

Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking

offsetting positions, often in different securities of the same issuer. For example, can

be long convertible bonds and short the underlying issuers equity. May also use

futures to hedge out interest rate risk. Focuses on obtaining returns with low or no

correlation to both the equity and bond markets. These relative value strategies

include fixed income arbitrage, mortgage backed securities, capital structure arbitrage,

and closed-end fund arbitrage. Expected Volatility: Low

Market Neutral - Securities Hedging: Invests equally in long and short equity

portfolios generally in the same sectors of the market. Market risk is greatly reduced,

but effective stock analysis and stock picking is essential to obtaining meaningful

results. Leverage may be used to enhance returns. Usually low or no correlation to the

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market. Sometimes uses market index futures to hedge out systematic (market) risk.

Relative benchmark index usually T-bills. Expected Volatility: Low

Market Timing: Allocates assets among different asset classes depending on the

manager's view of the economic or market outlook. Portfolio emphasis may swing

widely between asset classes. Unpredictability of market movements and the difficulty

of timing entry and exit from markets add to the volatility of this strategy. Expected

Volatility: High

Opportunistic: Investment theme changes from strategy to strategy as opportunities

arise to profit from events such as IPOs, sudden price changes often caused by an

interim earnings disappointment, hostile bids, and other event-driven opportunities.

May utilize several of these investing styles at a given time and is not restricted to any

particular investment approach or asset class. Expected Volatility: Variable

Multi Strategy: Investment approach is diversified by employing various strategies

simultaneously to realize short- and long-term gains. Other strategies may include

systems trading such as trend following and various diversified technical strategies.

This style of investing allows the manager to overweight or underweight different

strategies to best capitalize on current investment opportunities. Expected Volatility:

Variable

Short Selling: Sells securities short in anticipation of being able to rebuy them at a

future date at a lower price due to the manager's assessment of the overvaluation of

the securities, or the market, or in anticipation of earnings disappointments often due

to accounting irregularities, new competition, change of management, etc. Often used

as a hedge to offset long-only portfolios and by those who feel the market is

approaching a bearish cycle. High risk. Expected Volatility: Very High

Special Situations: Invests in event-driven situations such as mergers, hostile

takeovers, reorganizations, or leveraged buyouts. May involve simultaneous purchase

of stock in companies being acquired, and the sale of stock in its acquirer, hoping to

profit from the spread between the current market price and the ultimate purchase

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price of the company. May also utilize derivatives to leverage returns and to hedge out

interest rate and/or market risk. Results generally not dependent on direction of

market. Expected Volatility: Moderate

Value: Invests in securities perceived to be selling at deep discounts to their intrinsic

or potential worth. Such securities may be out of favor or under followed by analysts.

Long-term holding, patience, and strong discipline are often required until the ultimate

value is recognized by the market. Expected Volatility: Low - Moderate

Advantages of Hedge Funds over Mutual Funds

        Hedge funds are extremely flexible in their investment options because they use

financial instruments generally beyond the reach of mutual funds, which have SEC

regulations and disclosure requirements that largely prevent them from using short

selling, leverage, concentrated investments, and derivatives.

        This flexibility, which includes use of hedging strategies to protect downside

risk, gives hedge funds the ability to best manage investment risks.

        The strong results can be linked to performance incentives in addition to

investment flexibility. Unlike many mutual fund managers, hedge fund managers are

usually heavily invested in a significant portion of the funds they run and share the

rewards as well as risks with the investors. "Incentive fees" remunerate hedge fund

managers only when returns are positive, whereas mutual funds pay their financial

managers according to the volume of assets managed, regardless of performance. This

incentive fee structure tends to attract many of best practitioners and other financial

experts to the hedge fund industry.

        In the last nine years, the number of hedge funds has risen by about 20 percent

per year and the rate of growth in hedge fund assets has been even more rapid.

Currently, there are estimated to be approximately 8350 hedge funds managing $1

trillion. While the number and size of hedge funds are small relative to mutual funds,

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their growth reflects the importance of this alternative investment category for

institutional investors and wealthy individual investors.

CHAPTER VII: WORKINGS OF HEDGE FUNDS

A hedge fund is a private investment fund charging a performance fee and typically

open to only a limited range of qualified investors. In the United States, hedge funds

are open to accredited investors only. Because of this restriction, they are usually

exempt from any direct regulation by regulatory bodies. Alfred Winslow Jones is

credited with inventing hedge funds in 1949.

As a hedge fund's investment activities are limited only by the contracts governing the

particular fund, it can make greater use of complex investment strategies such as short

selling, entering into futures, swaps and other derivative contracts and leverage.

As their name implies, hedge funds often seek to offset potential losses in the

principal markets they invest in by hedging via any number of methods. However, the

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term "hedge fund" has come in modern parlance to be overused and inappropriately

applied to any absolute-return fund – many of these so-called "hedge funds" do not

actually hedge their investments.

Hedge funds have acquired a reputation for secrecy. Unlike open-to-the-public "retail"

funds (e.g. mutual funds) which market freely to the public, in most countries, hedge

funds are specifically prohibited from marketing to investors who are not professional

investors or individuals with sufficient private wealth. This limits the information a

hedge fund can legally release. Additionally, divulging a hedge fund's methods could

unreasonably compromise their business interests; this limits the information a hedge

fund would want to release.

Since hedge fund assets can run into many billions of dollars and will usually be

multiplied by leverage, their sway over markets, whether they succeed or fail, is

potentially substantial and there is a continuing debate over whether they should be

more thoroughly regulated.

Fees

Usually the hedge fund manager will receive both a management fee and a

performance fee (also known as an incentive fee). Performance fees are closely

associated with hedge funds, and are intended to incentivize the investment manager

to produce the largest returns possible.

Management fees

As with other investment funds, the management fee is calculated as a percentage of

the net asset value of the fund at the time when the fee becomes payable. Management

fees typically range from 1% to 4% per annum, with 2% being the standard figure.

Therefore, if a fund has $1 billion of assets at the year end and charges a 2%

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management fee, the management fee will be $20 million in total. Management fees

are usually calculated annually and paid monthly.

Performance fees

Performance fees, which give a share of positive returns to the manager, are one of the

defining characteristics of hedge funds. In contrast to retail investment firms,

performance fees are prohibited in the U.S. for stock brokers. A hedge fund's

performance fee is calculated as a percentage of the fund's profits, counting both

unrealized profits and actual realized trading profits. Performance fees exist because

investors are usually willing to pay managers more generously when the investors

have themselves made money. For managers who perform well the performance fee is

extremely lucrative.

Typically, hedge funds charge 20% of gross returns as a performance fee, but again

the range is wide, with highly regarded managers demanding higher fees.

Managers argue that performance fees help to align the interests of manager and

investor better than flat fees that are payable even when performance is poor.

However, performance fees have been criticized by many people, including notable

investor Warren Buffett, for giving managers an incentive to take excessive risk rather

than targeting high long-term returns. In an attempt to control this problem, fees are

usually limited by a high water mark and sometimes by a hurdle rate. Alternatively,

the investment manager might be required to return performance fees when the value

of the fund drops. This provision is sometimes called a ‘claw-back.’

High water marks

A "High water mark" is often applied to a performance fee calculation. This means

that the manager does not receive performance fees unless the value of the fund

exceeds the highest net asset value it has previously achieved. For example, if a fund

was launched at a net asset value (NAV) per share of $100, which then rose to $130 in

its first year, a performance fee would be payable on the $30 return for each share. If

the next year it dropped to $120, no fee is payable. If in the third year the NAV per

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share rises to $143, a performance fee will be payable only on the extra $13 return

from $130 to $143 rather than on the full return from $120 to $143.

This measure is intended to link the manager's interests more closely to those of

investors and to reduce the incentive for managers to seek volatile trades. If a high

water mark is not used, a fund that ends alternate years at $100 and $110 would

generate performance fee every other year, enriching the manager but not the

investors. However, this mechanism does not provide complete protection to

investors: a manager who has lost money may simply decide to close the fund and

start again with a clean slate -- provided that he can persuade investors to trust him

with their money. A high water mark is sometimes referred to as a "Loss Carry

forward Provision."

Poorly performing funds frequently close down rather than work without fees, as

would be required by their high water mark policies.

Hurdle rates

Some funds also specify a hurdle rate, which signifies that the fund will not charge a

performance fee until its annualized performance exceeds a benchmark rate, such as

T-bills or a fixed percentage, over some period. This links performance fees to the

ability of the manager to do better than the investor would have done if he had put the

money elsewhere.

Funds which specify a soft hurdle rate charge a performance fee based on the entire

annualized return. Funds which use a hard hurdle rate only charge a performance fee

on returns above the hurdle rate.

Though logically appealing, this practice has diminished as demand for hedge funds

has outstripped supply and hurdles are now rare.

Strategies

Hedge funds are no longer a homogeneous class. Under certain circumstances, an

investor or hedge fund can completely hedge the risks of an investment, leaving pure

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profit. For example, at one time it was possible for exchange traders to buy shares of,

say, IBM on one exchange and simultaneously sell them on another exchange, leaving

pure profit. Competition among investors has leached away such profits, leaving

hedge fund managers with trades that are partially hedged, at best. These trades still

contain residual risks which can be considerable. Some styles of hedge fund investing,

such as global macro investing, may involve no hedging at all. Strictly speaking, it is

not accurate to call such funds hedge funds, but that is current usage.

The bulk of hedge funds describe themselves as long / short equity, but many different

approaches are used taking different exposures, exploiting different market

opportunities, using different techniques and different instruments:

Global macro – seeking related assets that have deviated from some anticipated

relationship.

Arbitrage – seeking assets that are mispriced relative to related assets.

Convertible arbitrage – between a convertible bond and the same company's

equity.

Fixed income arbitrage – between related bonds.

Risk arbitrage – between securities whose prices appear to imply different

probabilities for one event.

Statistical arbitrage (or StatArb) – between securities that have deviated from

some statistically estimated relationship.

Derivative arbitrage – between a derivative and its security.

Long / short equity – generic term covering all hedged investment in equities.

Short bias – emphasizing or solely using short positions.

Equity market neutral – maintaining a close balance between long and short

positions.

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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 - arbitrage between an acquiring public company and a target

public company.

Other – the strategies below are sometimes considered hedge strategies,

although in several cases usage of the term is debatable.

Emerging markets- this usually means unhedged, long positions in small

overseas markets.

Fund of hedge funds - unhedged, long only positions in hedge funds (though

the underlying funds, of course, may be hedged). Additional leverage is

sometimes used.

130-30 funds - Through leveraging, 130% of the money invested in the fund is

used to buy stocks. 30% of the money invested in the fund is used to short

stock.

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CHAPTER VIII: HEDGE FUND RISK

Investing in a hedge fund is considered to be a riskier proposition than investing in a

regulated fund, despite the traditional notion of a "hedge" being a means of reducing

the risk of a bet or investment. The following are some of the primary reasons for the

increased risk:

Leverage - in addition to putting money into the fund by investors, a hedge fund will

typically borrow money, with certain funds borrowing sums many times greater than

the initial investment. Where a hedge fund has borrowed $9 for every $1 invested, a

loss of only 10% of the value of the investments of the hedge fund will wipe out 100%

of the value of the investor's stake in the fund, once the creditors have called in their

loans. At the beginning of 1998, shortly before its collapse, Long Term Capital

Management had borrowed over $26 for each $1 invested.

Short selling - due to the nature of short selling, the losses that can be incurred on a

losing bet are theoretically limitless, unless the short position directly hedges a

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corresponding long position. Therefore, where a hedge fund uses short selling as an

investment strategy rather than as a hedging strategy it can suffer very high losses if

the market turns against it.

Appetite for risk - hedge funds are culturally more likely than other types of funds to

take on underlying investments that carry high degrees of risk, such as high yield

bonds, distressed securities and collateralized debt obligations based on sub-prime

mortgages.

Lack of transparency - hedge funds is secretive entities. It can therefore be difficult

for an investor to assess trading strategies, diversification of the portfolio and other

factors relevant to an investment decision.

Lacks of regulation - hedge funds are not subject to as much oversight from financial

regulators, and therefore some may carry undisclosed structural risks.

Investors in hedge funds are willing to take these risks because of the corresponding

rewards. Leverage amplifies profits as well as losses; short selling opens up new

investment opportunities; riskier investments typically provide higher returns; secrecy

helps to prevent imitation by competitors; and being unregulated reduces costs and

allows the investment manager more freedom to make decisions on a purely

commercial basis.

Legal structure

A hedge fund is a vehicle for holding and investing the funds of its investors. The

fund itself is not a genuine business, having no employees and no assets other than its

investment portfolio and a small amount of cash, and its investors being its clients.

The portfolio is managed by the investment manager, which has employees and

property and which is the actual business. An investment manager is commonly

termed a “hedge fund” (e.g. a person may be said to “work at a hedge fund”) but this

is not technically correct. An investment manager may have a large number of hedge

funds under its management.

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Domicile

The specific legal structure of a hedge fund – in particular its domicile and the type of

entity used – is usually determined by the tax environment of the fund’s expected

investors. Regulatory considerations will also play a role. Many hedge funds are

established in offshore tax havens so that the fund can avoid paying tax on the

increase in the value of its portfolio. An investor will still pay tax on any profit it

makes when it realizes its investment, and the investment manager, usually based in a

major financial center, will pay tax on the fees that it receives for managing the fund.

At the end of 2004 55% of the world’s hedge funds, accounting for nearly two-thirds

of total hedge fund assets, were established offshore. The most popular offshore

location was the Cayman Islands, followed by the British Virgin Islands, Bermuda and

the Bahamas. The US was the most popular onshore location, accounting for 34% of

funds and 24% of assets. EU countries were the next most popular location with 9% of

funds and 11% of assets. Asia accounted for the majority of the remaining assets.

The legal entity

Limited partnerships are principally used for hedge funds aimed at US-based investors

who pay tax, as the investors will receive relatively favorable tax treatment in the US.

The general partner of the limited partnership is typically the investment manager

(though is sometimes an offshore corporation) and the investors are the limited

partners. Offshore corporate funds are used for non-US investors and US entities that

do not pay tax (such as pension funds), as such investors do not receive the same tax

benefits from investing in a limited partnership. Unit trusts are typically marketed to

Japanese investors. Other than taxation, the type of entity used does not have a

significant bearing on the nature of the fund.

Many hedge funds are structured as master/feeder funds. In such a structure the

investors will invest into a feeder fund which will in turn invest all of its assets into

the master fund. The assets of the master fund will then be managed by the investment

manager in the usual way. This allows several feeder funds (e.g. an offshore corporate

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fund, a US limited partnership and a unit trust) to invest into the same master fund,

allowing an investment manager the benefit of managing the assets of a single entity

while giving all investors the best possible tax treatment.

The investment manager, which will have organized the establishment of the hedge

fund, may retain an interest in the hedge fund, either as the general partner of a limited

partnership or as the holder of “founder shares” in a corporate fund. Founder shares

typically have no economic rights, and voting rights over only a limited range of

issues, such as selection of the investment manager – most of the fund’s decisions are

taken by the board of directors of the fund, which is self-appointing and independent

but invariably loyal to the investment manager.

Open-ended nature

Hedge funds are typically open-ended, in that the fund will periodically issue

additional partnership interests or shares directly to new investors, the price of each

being the net asset value (“NAV”) per interest/share. To realize the investment, the

investor will redeem the interests or shares at the NAV per interest/share prevailing at

that time. Therefore, if the value of the underlying investments has increased (and the

NAV per interest/share has therefore also increased) then the investor will receive a

larger sum on redemption than it paid on investment. Investors do not typically trade

shares between themselves and hedge funds do not typically distribute profits to

investors before redemption. This contrasts with a closed-ended fund, which has a

limited number of shares which are traded between investors, and which distributes its

profits.

Listed funds

Corporate hedge funds often list their shares on smaller stock exchanges, such as the

Irish Stock Exchange, in the hope that the low level of quasi-regulatory oversight will

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give comfort to investors and to attract certain funds, such as some pension funds, that

have bars or caps on investing in unlisted shares. Shares in the listed hedge fund are

not traded on the exchange, but the fund’s monthly net asset value and certain other

events must be publicly announced there.

A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in

an investment manager. Although widely reported as a "hedge-fund IPO", the IPO of

Fortress Investment Group LLC was for the sale of the investment manager, not of the

hedge funds that it managed.

Hedge fund management worldwide

In contrast to the funds themselves, hedge fund managers are primarily located

onshore in order to draw on larger pools of financial talent. The US East coast –

principally New York City and the Gold Coast area of Connecticut (particularly

Stamford and Greenwich) – is the world's leading location for hedge fund managers

with approximately double the hedge fund managers of the next largest center,

London. With the bulk of hedge fund investment coming from the US, this

distribution is natural.

London is Europe’s leading center for the management of hedge funds. At the end of

2006, three-quarters of European hedge fund investments, totaling $400bn (£200bn),

were managed from London, having grown from $61bn in 2002. Australia was the

most important center for the management of Asia-Pacific hedge funds, with

managers located there accounting for approximately a quarter of the $140bn of hedge

fund assets managed in the Asia-Pacific region in 2006.

Regulatory Issues

Part of what gives hedge funds their competitive edge, and their cachet in the public

imagination, is that they straddle multiple definitions and categories; some aspects of

their dealings are well-regulated, others are unregulated or at best quasi-regulated.

Offshore regulation

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Many offshore centers are keen to encourage the establishment of hedge funds. To do

this they offer some combination of professional services, a favorable tax

environment, and business-friendly regulation. Major centers include Cayman Islands,

Dublin, Luxembourg, British Virgin Islands and Bermuda. The Cayman Islands have

been estimated to be home to about 75% of world’s hedge funds, with nearly half the

industry's estimated $1.225 trillion AUM[11].

Hedge funds have to file accounts and conduct their business in compliance with the

requirements of these offshore centers. Typical rules concern restrictions on the

availability of funds to retail investors (Dublin), protection of client confidentiality

(Luxembourg) and the requirement for the fund to be independent of the fund

manager.

Many offshore hedge funds, such as the Soros funds, are structured as mutual funds

rather than as limited partnerships.

Hedge Fund Indices

There are a number of indices that track the hedge fund industry. These indices come

in two types, Investable and Non-investable, both with substantial problems. There are

also new types of tracking product launched by Goldman Sachs and Merrill Lynch,

"clone indices" that aim to replicate the returns of hedge fund indices without actually

holding hedge funds at all.

Investable indices are created from funds that can be bought and sold, and only Hedge

Funds that agree to accept investments on terms acceptable to the constructor of the

index are included. Investability is an attractive property for an index because it makes

the index more relevant to the choices available to investors in practice, and is taken

for granted in traditional equity indices such as the S&P500 or FTSE100. However,

such indices do not represent the total universe of hedge funds and may under-

represent the more successful managers, who may not find the index terms attractive.

Fund indexes include Barclay Hedge, Hedge Fund Research, Eureka hedge Indices,

Credit Suisse Tremont and FTSE Hedge.

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The index provider selects funds and develops structured products or derivative

instruments that deliver the performance of the index, making investable indices

similar in some ways to fund of hedge funds portfolios.

Non-investable benchmarks are indicative in nature, and aim to represent the

performance of the universe of hedge funds using some measure such as mean,

median or weighted mean from a hedge fund database. There are diverse selection

criteria and methods of construction, and no single database captures all funds. This

leads to significant differences in reported performance between different databases.

Non-investable indices inherit the databases' shortcomings, or strengths, in terms of

scope and quality of data. Funds’ participation in a database is voluntary, leading to

“self-reporting bias” because those funds that choose to report may not be typical of

funds as a whole. For example, some do not report because of poor results or because

they have already reached their target size and do not wish to raise further money.

This tends to lead to a clustering of returns around the mean rather than representing

the full diversity existing in the hedge fund universe. Examples of non-investable

indices include an equal weighted benchmark series known as the HFN Averages, and

revolutionary rules based set known as the Lehman Brothers/HFN Global Index Series

which leverages an Enhanced Strategy Classification System.

The short lifetimes of many hedge funds means that there are many new entrants and

many departures each year, which raises the problem of “survivorship bias”. If we

examine only funds that have survived to the present, we will overestimate past

returns because many of the worst-performing funds have not survived, and the

observed association between fund youth and fund performance suggests that this bias

may be substantial. As the HFR and CISDM databases began in 1994, it is likely that

they will be more accurate over the period 1994/2000 than the Credit Suisse database,

which only began in 2000.

When a fund is added to a database for the first time, all or part of its historical data is

recorded ex-post in the database. It is likely that funds only publish their results when

they are favorable, so that the average performances displayed by the funds during

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their incubation period are inflated. This is known as "instant history bias” or “backfill

bias”.

In traditional equity investment, indices play a central and unambiguous role. They are

widely accepted as representative, and products such as futures and ETFs provide

liquid access to them in most developed markets. However, among hedge funds no

index combines these characteristics. Investable indices achieve liquidity at the

expense of representativeness. Non-investable indices are representative, but their

quoted returns may not be available in practice. Neither is wholly satisfactory.

Debates and controversies

Privacy issues

As private, lightly regulated partnerships, hedge funds do not have to disclose their

activities to third parties. This is in contrast to a fully regulated mutual fund (or unit

trust) which will typically have to meet regulatory requirements for disclosure. An

investor in a hedge fund usually has direct access to the investment advisor of the

fund, and may enjoy more personalized reporting than investors in retail investment

funds. This may include detailed discussions of risks assumed and significant

positions. However, this high level of disclosure is not available to non-investors,

contributing to hedge funds' reputation for secrecy. Several hedge funds are

completely "black box", meaning that their returns are uncertain to the investor.

Restrictions on marketing and the lack of regulation is that there are no official hedge

fund statistics. An industry consulting group, HFR (hfr.com), reported at the end of

the second quarter 2003 that there are 5,660 hedge funds worldwide managing $665

billion. For comparison, at the same time the US mutual fund sector held assets of

$7.818 trillion (according to the Investment Company Institute).

Market capacity

Analysis of the rather disappointing hedge fund performance in 2004 and 2005 called

into question the alternative investment industry's value proposition. Alpha may have

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been becoming rarer for two related reasons. First, the increase in traded volume may

have been reducing the market anomalies that are a source of hedge fund performance.

Second, the remuneration model is attracting more and more managers, which may

dilute the talent available in the industry.

However, the market capacity effect has been questioned by the EDHEC Risk and

Asset Management Research Centre through a decomposition of hedge fund returns

between pure alpha, dynamic betas, and static betas.

While pure alpha is generated by exploiting market opportunities, the dynamic betas

depend on the manager’s skill in adapting the exposures to different factors, and these

authors claim that these two sources of return do not exhibit any erosion. This

suggests that the market environment (static betas) explains a large part of the poor

performance of hedge funds in 2004 and 2005.

Systematic risk

Hedge funds came under heightened scrutiny as a result of the failure of Long-Term

Capital Management (LTCM) in 1998, which necessitated a bailout coordinated by

the U.S. Federal Reserve. Critics have charged that hedge funds pose systemic risks

highlighted by the LTCM disaster. The excessive leverage (through derivatives) that

can be used by hedge funds to achieve their return is outlined as one of the main

factors of the hedge funds contribution to systematic risk.

The ECB (European Central Bank) has issued a warning on hedge fund risk for

financial stability and systemic risk: "... the increasingly similar positioning of

individual hedge funds within broad hedge fund investment strategies is another major

risk for financial stability which warrants close monitoring despite the essential lack

of any possible remedies. This risk is further magnified by evidence that broad hedge

fund investment strategies have also become increasingly correlated, thereby further

increasing the potential adverse effects of disorderly exits from crowded trades."

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The Times wrote about this review: "In one of the starkest warnings yet from an

official institution over the role of the burgeoning but secretive industry, the ECB

sounded a note of alarm over the possible repercussions from any collapse of a hedge

fund, or group of funds."

However, the ECB statement itself has been criticized by a part of the financial

research community. These arguments are developed by the EDHEC Risk and Asset

Management Research Centre: The main conclusions of the study are that “the ECB

article’s conclusion of a risk of “disorderly exits from crowded trades” is based on

mere speculation. While the question of systemic risk is of importance, we do not

dispose of enough data to reliably address this question at this stage”; “it would be

worthwhile for financial regulators to work towards obtaining data on hedge fund

leverage and counterparty credit risk. Such data would allow a reliable assessment of

the question of systemic risk”, and “besides evaluating potential systemic risk, it

should be recognized that hedge funds play an important role as “providers of

liquidity and diversification”.

The potential for systemic risk was highlighted by the near-collapse of two Bear

Stearns hedge funds in June 2007. The funds invested in mortgage-backed securities.

The funds' financial problems necessitated an infusion of cash into one of the funds

from Bear Stearns but no outside assistance. It was the largest fund bailout since Long

Term Capital Management's collapse in 1998. The U.S. Securities and Exchange

Commission is investigating.

Performance measurement

The issue of performance measurement in the hedge fund industry has led to literature

that is both abundant and controversial. Traditional indicators (Sharpe, Treynor,

Jensen) work best when returns follow a symmetrical distribution. In that case, risk is

represented by the standard deviation. Unfortunately, hedge fund returns are not

normally distributed, and hedge fund return series are auto correlated. Consequently,

traditional performance measures suffer from theoretical problems when they are

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applied to hedge funds, making them even less reliable than is suggested by the

shortness of the available return series.

Innovative performance measures have been introduced in an attempt to deal with this

problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003), Omega by Keating

and Shadwick (2002), Alternative Investments Risk Adjusted Performance (AIRAP)

by Sharma (2004), and Kappa by Kaplan and Knowles (2004). An overview of these

performance measures is available in Géhin, W., 2006, The Challenge of Hedge Fund

Performance Measurement: a Toolbox rather than a Pandora’s Box, EDHEC Risk and

Asset Management Research Center, Position Paper, December. However, there is no

consensus on the most appropriate absolute performance measure, and traditional

performance measures are still widely used in the industry.

Relationships with analysts

In June 2006, the U.S. Senate Judiciary Committee began an investigation into the

links between hedge funds and independent analysts, and other issues related to the

funds. Connecticut Attorney General Richard Blumenthal testified that an appeals

court ruling striking down oversight of the funds by federal regulators left investors

"in a regulatory void, without any disclosure or accountability." The hearings heard

testimony from, among others, Gary Aguirre, a staff attorney who was recently fired

by the SEC.

Transparency

Some hedge funds, mainly American, do not use third parties either as the custodian

of their assets or as their administrator (who will calculate the NAV of the fund). This

can lead to conflicts of interest, and in extreme cases can assist fraud. In a recent

example, Kirk Wright of International Management Associates has been accused of

mail fraud and other securities violations which allegedly defrauded clients of close to

$180 million.

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CHAPTER IX: THE SCENARIO IN INDIA

More than a dozen hedge funds have received the regulatory nod after the Securities

and Exchange Board of India (SEBI) allowed hedge fund-like strategies to launch

operations in India under alternative investment fund (AIF) Category-III segment.

The funds that got the regulatory green signal include Avendus India, Karvy Capital,

Motilal Oswal, Capveda, DSP BlackRock, Edelweiss and Ambit Capital. The other

hedge funds that received SEBI’s approval are Forefront, Unifi AIF, Malabar Capital,

Monsoon Alternative Investment, Redart India and Mavenvest Absolute Return Fund.

One hedge fund, SBI Pipe Fund, is awaiting approval.

A popular product overseas, hedge funds in India are in their infancy. They are similar

to mutual funds in the way they pool in investors’ money and invest it in stocks and

stocks derivatives and bonds, and returns are distributed among unitholders. Unlike

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MFs, hedge funds use far more complex strategies, such as long-short, derivatives and

leverage, among others.

Hedge funds have gained popularity abroad with increasing volatility in global

markets, as they are viewed as risky but money-spinning products.

Till now, Indian investors had to invest money in long-only funds such as portfolio

management services (PMS) and they had no way to bet against the market.

Sebi’s new rules for alternative investment funds Category III segment allows hedge

fund-like strategies such as short selling. Short sales or selling a stock that one does

not own are prohibited in PMS schemes.

Till the new local hedge funds are allowed, only foreign investors could participate in

hedge funds through Mauritius or other offshore-based funds.

In addition to short selling, hedge funds can leverage twice their assets, meaning an

India hedge fund of Rs 100 crore assets can take bets worth up to Rs 200 crore,

according to Sebi.

The total asset size of local hedge funds in India is not known. The minimum ticket

size for investors putting money in these hedge funds is Rs 1 crore. This is to ensure

small investors are kept away from betting on these risky strategies.

“The total funds managed by hedge funds in India may be in the region of Rs 300-500

crore,” said a fund manager, adding that Karvy, Ambit, Forefront and Capveda are up

and running while others are just starting off.

“Most fund houses may be managing just Rs 30-40 crore or even lower. Most of this

too are proprietary money,” said an industry official. The law stipulates AIF Category

III to have minimum of Rs 20 crore of assets under management (AUM).

“Some funds are up and running while most others are in fund raising mode right

now,” said another industry official.

Regulatory Issue for Hedge Funds in India

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With the notification of SEBI (Mutual Fund) Regulations 1993, 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. We have however, no information about

any hedge funds domiciled in India. Further, on account of limited convertibility,

offshore hedge funds have yet to offer their products to Indian investors within India.

Recently, RBI through liberalized remittance scheme, allowed resident individuals to

remit upto US $ 25,000 per year for any current or capital account transaction. The

liberalized scheme will allow Indian individual investors to explore the possibility of

investing in offshore financial products. Considering the existing limit being only US

$ 25,000 per year, Indian market may not be attractive to hedge fund product

marketing. As long as there will be restriction on capital account convertibility,

foreign hedge funds, by virtue of their minimum investment limit being $ 100,000 or

higher, do not seem to be excited to access investment from Indian investors in India.

It may be clearly understood that the suggestions put forth in the following paragraphs

are in no way aimed at allowing foreign hedge funds to mobilise investment from

India by offering their products to Indian investors. Therefore regulatory issues related

to investor protection have not been considered for this Report.

Some hedge funds have invested in offshore derivative instruments (PNs) issued by

FIIs against underlying Indian securities. Through this route hedge funs can derive

economic benefit of investing in Indian securities without directly entering the Indian

market as FIIs or their sub-accounts. 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. As at the end of

March, 2004, total investment by hedge funds. In the offshore derivative instruments

(PNs) against Indian equity, are Rs. 8050 crores which represents about 8% total net

equity investments of all FIIs. On the basis of market value, the hedge funds account

for about 5% of the market value of the total assets held by the FIIs in India.

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The current fiscal year (2003-2004) has seen a spectacular increase in FII activities in

Indian market. Till this report is filed FIIs have already invested US $ 10 bn. during

this year alone which is a record. Robust economic fundamentals, strong corporate

earnings and improvement in market micro structure are driving the FII interest in

India. Investors all over the world are keen to come to Indian market. From informal

discussions with institutional investors including some reputed and well established

hedge funds, one could gauge the extent of interest they have about Indian markets.

During the discussions they have requested whether India, like other Asian emerging

markets, can provide a regulatory framework that will allow them to directly invest in

Indian market in a transparent manner. In this context , the following approach may be

considered for allowing the well-established hedge funds to invest in Indian markets

as a registered entity under the SEBI (Foreign Institutional Investors) Regulations,

1995.

Relevant Provisions of FII Regulations:

Though 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. Regulation 6 (i)

(b) of the FII Regulations requires an FII applicant to be a regulated entity in its place

of incorporation or operations.

The FII Regulations allow sub-accounts sponsored by registered FIIs to invest in

India. Regulation 2 (k) defines “sub-account” which “includes foreign corporates or

foreign individuals and those institutions, established or incorporated outside India

and those funds, or portfolios, established outside India, whether incorporated or not,

on whose behalf investments are proposed to be made in India 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

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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, it must be remembered that 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.

Identifying Hedge Funds

As mentioned in earlier paragraphs, hedge funds do not have, any universally accepted

definition. Therefore, identifying a hedge fund is the first challenge that a regulator

faces. An approach for identifying hedge funds, as suggested by IOSCO is to look at

the kinds of characteristics of fund management strategies employed by institutions.

Hedge funds would at least exhibit some of the following characteristics:

Borrowing and leverage restrictions, which are typically included in Mutual

Fund Regulation are not applied, and many (but not all) hedge funds use high

levels of leverage.

Significant performance fees (often in the form or percentage of profits) are

paid to the manager in addition to an annual management fees.

Investors are typically permitted to redeem their interests periodically, e.g.

quarterly, semi-annually or annually;

Often significant ‘own’ funds are invested by manager;

Derivatives are used, often for speculative purposes, and there is an ability to

short sell securities;

More diverse risks or complex underlying products are involved.

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The distinguishing characteristics of hedge funds are not limited to this and the list

may need to adapt depending on the changing market dynamics. Further, it might be

appropriate to also consider the investment strategy followed by particular funds, such

as long/short exposures, leverage and / or hedging and arbitrage techniques. On the

basis of these characteristics, it will be possible to identify an applicant as a hedge

fund.

Investment limits applicable to FIIs:

Chapter II of the SEBI (Foreign Institutional Investors) Regulations, 1995 interalia list

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

will not 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. Further, through circular No.

SMD/DC/CIR-11/02 dated February 12, 2002 and SEBI/DNAD/CIR -21/2004/03/09

dated March 9, 2004 issued by Secondary Market Department, position limits for

investment by FIIs in derivatives have been advised. These limits will help diversify

the foreign hedge fund investments and will help in jettisoning concentration in any

specific scrip. The provisions of Chapter III (Regulation 15 (3) (a)) disallows short

selling by FIIs and stipulates that all trades by FIIs are delivery based. The provision

will clearly keep the hedge funds if allowed to invest as FIIs out of short selling at

least in the cash segment. It is therefore, clear that existing provisions in the FII

Regulations include several checks and balances which can keep our market safe from

potential market abuse and manipulation.

Additional Regulatory Concerns:

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

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SEBI (Foreign Institutional Investors) Regulations. While opening up our market one

cannot be oblivious to the special concerns associated with the creative fund

management strategies used by these funds. Thus, the approach adopted in

formulating the following policy suggestions has been that of transparent and

regulated access with abundant caution. Para 4.4 of this section has already outlined

the existing provisions in the SEBI (Foreign Institutional Investors) Regulations, 1995

and the Guidelines issued by SEBI which an address the concerns related to currency

speculations, short selling, scrip wise concentration in the cash market and excessive

positions in the derivative segment of our market. As mentioned earlier, these types of

funds raise special regulatory concerns which are necessary to be addressed with

special regulatory provisions. In this context, following additional provisions have

been suggested with respect to hedge funds seeking registration as FII :

The investment adviser to the hedge funds should be a regulated investment

advisor under the relevant Investor Advisor Act or the fund is registered under

Collective Investment Fund Regulations or Investment Companies Act .

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.

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).

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. This provision is expected to allow well managed funds to

access our market and at the same time, keep our markets insulated from the

possible adverse effects of ‘trial and errors’ by uninitiated rookies.

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Hedge funds as a whole are becoming an important segment of the asset management

industry and gaining popularity from investors particularly from the high net worth

investors, universities, charitable funds, endowments, pension funds, insurance and

other institutional investors. The asset under management of the hedge funds are

growing on a double digit rate. All hedge funds are not necessarily speculative funds

though most of them provide an alternative investment options for the investors

through innovative investment strategy.

The issues discussed and suggestions placed above are intended to widen the FII

window to allow these alternatives invest pools to our 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. The

alternative investment pools if allowed to investment in Indian markets will be a

source of additional liquidity and will also diversify the pool of foreign investments in

Indian market.

CHAPTER XI: CASE STUDIES

Karvy Capital

Case Study: Business Owner

Mr. Murthy (52 years old) is the MD of a legal outsourcing company – Marathon

Solutions, based out of Bangalore. The company has a total of 70 employees across

functions and an annual revenue run-rate of ~Rs. 60crs. The clients are primarily

based out of the US.  Mr. Murthy owns 55% in the company - 35% is controlled by

his brother who is the Chief Operating Officer and the remaining 10% is owned by

employees of the company.

Family of Mr. Murthy

Mrs. Ritu -his wife is an interior designer. She is 48 years old. They have one

daughter Neha (26 years old) and one son Rahul (19 years old). Neha is married and

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settled in Kolkata. Rahul is currently studying in SY B.Com – he intends to pursue an

international MBA in 4 years time.

Personal Portfolio

Equity - 18crs: The direct equity portfolio had a total of 73 stocks with a current

market value of 12crs. The stocks have been added to his portfolio over a period of

time and are diversified across sectors and market capitalization. The total mutual

fund investment corpus is Rs. 4.5crs which has been invested in a total of 13 schemes

primarily in NFOs and closed ended schemes. The current value of the same is Rs

3.8crs. Rs 2 crs was invested in a mid-cap Portfolio Management Service (PMS)

managed by a local brokerage house. The money was invested in 2 tranches of 1cr

each in 2005 and 07. The current value of the same is Rs. 2.1crs.

Debt - 1.2crs: There is a total of 45L lying in various bank fixed deposits across

tenures. The average maturity of the same is ~3 years. Besides this, the total PPF

contribution across the family holders is 70L. The family also owns 8L in NSCs.

Real Estate – 7crs: The primary residence in Bangalore is worth Rs. 4crs in market

value. There is a loan outstanding of Rs. 1cr against it with an EMI of Rs. 150,000 per

month. Besides, Mr. Murthy owns a flat in Mumbai valued at Rs.3crs and a plot of

land near Delhi worth 1cr.

Private Equity: Mr. Murthy has a commitment of Rs. 1cr to a private equity fund.

Out of this a total of Rs.25L has been drawn down and a further 25L drawdown is

expected this year. Cash: The current savings bank account balance is Rs. 35L

Recommendations

Personal Portfolio

1. KARVY Private Wealth helped to outline the key financial goals of the family

which included building a retirement corpus for Mr. Murthy, a education fund

for Rahul and a gift of Rs. 50L to Neha when she turns 30.

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2. The current portfolio was heavily skewed toward equity (70%) and real estate

(25%). KPW recommended increasing the debt component of the portfolio in

line with building up an retirement corpus for Mr. Murthy. The target asset

allocation at the end of the financial year was as follows:- 

Equity: 45% 

Debt: 30% 

Real Estate: 25% 

Gold : 5% 

3. KPW analyzed the Mutual Fund (MF) portfolio and recommended divesting 6

out of the 13 mutual fund schemes which had been underperforming the

markets. The surplus cash from this was used to build up the debt component

of the portfolio through purchase of NABARD and PFC bonds. Part of the

money was invested in 3 year bank fixed deposits as well.

4. The number of stocks in the current direct equity portfolio was too high

resulting in poor decision making on the portfolio and underperformance to the

market. The top 6 stocks made up over 55% of the portfolio. We divided the

portfolio into a “Core” and a “Satellite” portfolio. The “core” included 12 large

cap stocks and comprised 70% of the total portfolio. The other 30% was

designated as the “Satellite” portfolio and comprised of 8 stocks. The stocks in

this segment were mostly midcap and small cap in nature. No more than 5% of

the portfolio was invested in one stock and the exposure of any sector was

maintained below 20%. The remaining stocks were sold.  

5. The PMS fund had been underperforming the mid-cap index by over 8% since

inception. KPW recommended exiting the same once the lock in for the same

was completed. The proceeds were to be recommended in debt instruments. 

6. The current housing loan was with a leading private bank at a floating rate of

12%. KPW analyzed the current loan rates in the market and recommended

switching the loan to a PSU bank which provided the loan at a floating rate of

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10.5%. 20L of the surplus cash was used to prepay part of the housing loan as

well.

7. The financial goals with respect to the children were well managed for. The

commitment to the private-equity fund would be made from internal accruals

through the year.

Corporate Portfolio

1. FX Hedging 

Almost all the revenues (~90%) of the company were USD denominated

whereas the costs were mostly INR in nature (~60%). The company policy was

to remit USD back to India on an ad-hoc manner using spot rates in the

currency market. As a result the reported revenues of the company had been

extremely volatile. 

KARVY Private Wealth designed a FX hedging strategy for the company

based on the payments expected from the clients and the costs to be incurred in

the foreign country. This ensured the currency risk was managed better for a

majority of the remittances to be made for the current financial year. 

The execution of the entire strategy was carried out by KPW using a

combination of currency futures available on the exchanges for shorter dated

exposure (<3 months) and forward contracts with a PSU bank for contracts

with a longer dated tenure.

2. Managing Liquid Cash Effectively

The surplus cash lying with the company (on an average~ 40L) was being

invested in a single liquid fund floated by the Royal Fund Manager. On

analysis by KPW, we found the following issues with the current investment in

the liquid fund:- 

Lack of diversification

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Mismatch in tenure of requirements of funds and investment horizon

Additional risk given the high exposure to real estate and NBFCs 

KPW recommended the following steps to address the issue:- 

Broaden the range of investments chosen

Increase number of liquid funds to diversify risk. These funds were

chosen on the basis of the current portfolio, past returns, track record of

the fund manager and the stability of the fund house in managing debt

schemes. 

Minimize credit risk across the investments

Percentage Allocation Time Horizon

Liquid Funds 40% <3 months

FMP/FDs – 12 months 25% 12 months

Structured Products with Capital Protection 10% 18-24 months

Corporate Bonds 25% 3 years

Case Study: Corporate Professional

Vishal: Senior Executive earning Rs. 40 lakh a year

Amrita: Marketing consultant earning ~Rs. 25 lakh a year – not fulltime in nature

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Daughter Nidhi: 8 years old

Existing assets

• Own house: Rs. 80 lakh in market value; loan outstanding of Rs. 40 lakh against it

with an EMI of Rs. 55,000 per month – entirely in Vishal’s name owing to the salaried

job.

• Plot of land purchased from Amrita’s savings in joint name: Cost value Rs. 7 lakh,

worth Rs. 11 lakh now

• Public Provident Fund (PPF): Rs. 8 lakh in Vishal’s name, Rs. 9 lakh in Amrita’s

name and Rs. 3 lakh in Nidhi’s name

• Employee Provident Fund (EPF): Rs. 7 lakh in Vishal’s name

• Fixed Deposits (FDs): Rs. 15 lakh held jointly earning 8%

• Insurance

1. Rs. 20 lakh for Vishal through a combination of policies and another Rs. 60

lakh from his employer

2. Rs. 35 lakh for Amrita.

3. Surrender value of insurance policies: Rs. 12 lakh across Vishal and Amrita.

Payout of Rs. 40 lakh expected in 10 years’ time; annual insurance linked

investments are Rs. 1 lakh.

• Health cover as provided by Vishal’s employer – Rs. 3 lakh floating cover for the

family

• Equity holdings

1. Mutual funds: Rs. 4 lakh, not actively managed – total of 13 schemes including

some NFOs and closed ended schemes

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2. Equity stocks: Amrita’s demat has stocks worth Rs. 3 lakh which she manages

semiactively (12 stocks)

• Other investments: A real estate fund they bought in joint name two years back – at

cost value of Rs. 10 lakh

• Current bank balance is Rs. 7 lakh – not invested anywhere owing to lack of suitable

opportunities.

Milestones

• Related to Nidhi – education in 10 years from now at Rs. 20 lakh in today’s rupees;

higher education in 14 years from now at Rs. 40 lakh in today’s rupees; marriage in 17

years from now at Rs. 30 lakh in today’s rupees and finally a gift of Rs. 50 lakh (if

possible) in 18 years from now

• Amrita is thinking of bolstering her consulting practice by hiring a couple of

associates and taking up a fulltime office. This would entail a spend of Rs. 8 lakh over

the period of a year

• Vishal and Amrita are thinking of buying a new car for Rs. 11 lakh. They are

thinking about taking a loan for the same.

• Vishal has been using his bonus to retire the home loan which had become quite

costly in last year. He plans to do the same this year as well. The estimated bonus

amount is Rs. 8 lakh.

Portfolio view and shuffle - Investment portfolio

• Total real estate: Rs. 21 lakh

• Equity: Rs. 11 lakh (including Rs. 4 lakh from insurance surrender value)

• Debt: Rs. 50 lakh (including Rs. 8 lakh from insurance surrender value)

• Cash: Rs. 7 lakh

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• Total: Rs. 89 lakh

Following observations/recommendations emerge

• The portfolio is quite skewed towards debt – owing to the investments in PPF, EPF,

insurance policies and FDs. Of these only the FDs are semi-liquid and the insurance

policies can be altered with some costs. The others are unalterable.

• Hence we suggest that the Fixed Deposits be invested in other assets such as equity

and alternate investments.

• The cash balance is sufficient but should be redirected into liquid funds to maximize

the returns from cash holdings without sacrificing liquidity

• The real estate allocation is sufficient. It need not be altered. The alternative assets

can be chosen from Private Equity (PE) funds, commodities or international

investments.

• Within the equity allocation, mutual funds portfolio should be evaluated and

restructured as needed. The equity stock portfolio can remain as it is currently –

though it can be managed more actively

• Some of the incremental equity allocation can be done through structured products

which will ensure protection from near term downside

Risk management observations

• Vishal’s total cover is barely adequate. Also it is subject to his continued

employment with the present employer (or the new employer providing similar cover).

Vishal should take Rs. 50 lakh of term insurance

• Amrita’s life cover is sufficient.

• The family should take additional medical insurance to build the policy history –

irrespective of the employer. The family should also add critical illness cover since it

is missing in the current set-up

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• The family should insure their home and belongings.

• Amrita can think about professional indemnity cover depending on her client profile

Milestones

• Vishal and Amrita need to start keeping aside Rs. 25,000 for their daughter’s

education and marriage. They should use two different policies for education and

marriage and invest the same in child plans with moderate risk profile

• For the Nidhi gift fund, they can invest Rs. 10,000/- in equity linked child plan with

aggressive risk profile.

• Amrita’s business venture can be comfortably financed by the savings currently with

the family. However a careful business planning and cashflow based evaluation is

called for to justify the investment in light of its payoffs

• The car can be purchased as well. However, it would not make sense to retire a low

cost loan (home loan) and take on a high cost loan (car loan). Hence the bonus should

be used for the down payment of the car rather than home loan retirement. While

thinking about prepayment in future, the car loan should take precedence since it is

higher cost and one without tax benefits.

• In general the risk taking ability of the family is moderate to high. They need not

retire their home loan that aggressively. Instead they can use the funds to build long

term assets – with at least 10% rate of return in neutral markets.

Case Study: Self Employed Professional

Name: Dr. Asmita Shinde (42 years)

Spouse: Prof. Gururaj Gokhale (45 years)

Son: Vidhan (18 years)

Existing assets

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• Equity mutual funds: Rs. 3 lakh

• Equity stocks: Rs. 32 lakh (Rs. 29 lakh of this in three stocks Reliance Industries

Ltd, HDFC Ltd and L&T)

• Public Provident Fund (PPF): Rs. 8 lakh

• Fixed Deposits: Rs. 13 lakh

• Insurance policies surrender value (cover)

1. Endowment: Dr. Asmita - Rs. 12 lakh (Rs. 22 lakh)

2. ULIP: Dr Asmita - Rs. 6 lakh (Rs. 20 lakh)

3. Term: Prof. Gokhale - Nil (Rs. 50 lakh)

• Clinic run by Dr. Asmita: Rs. 20 lakh for property and Rs. 12 lakh for equipment at

cost

• Own home worth Rs. 1.2 Cr with no loan against it.

Milestones

• Dr. Asmita is keen to join hands with few other doctors and offer a holistic

diagnostic clinic to patients. She has thought about a plan which requires her to leave

her current clinic and relocate her practice to a larger center. She may also have to

contribute in terms of initial set up cost to the tune of Rs. 8 lakh

• Both Dr Asmita and Prof Gokhale have been thinking about creating an education

trust for sponsoring education of bright students in need. They have necessary

approvals to create such a trust. They are thinking of allocating Rs. 5 lakh to this trust

to start with and then add Rs. 2 lakh every year to the trust’s corpus. They are thinking

that the money for the trust can be managed such that 8-10% returns can be generated

for the scholarships every year.

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• Dr Asmita and Prof Gokhale are looking to plan for their retirement. They are

thinking of keeping building a total corpus of Rs. 1.5 Cr in next 10 years (including

current assets) after paying for their son’s higher education – budgeted at Rs. 30 lakh

in 3 years. They are expecting this to be sufficient for generating Rs. 1 lakh of

income per month post retirement (in the retirement year’s rupees)

Portfolio view: observations and recommendations

• The equity portfolio is highly concentrated. The downside risk of such a portfolio is

quite high. Also the decision to stick to the portfolio is likely to be driven by inertia

rather than specific analysis. It is recommended that the family should build a more

diversified portfolio of at least 10 stocks if they are planning to monitor is actively and

4-5 mutual funds if their management is unlikely to be very active.

• The overall portfolio allocation is as follows

1. Debt: Rs. 43 lakh

2. Equity: Rs. 41 lakh

3. Real estate: Rs. 20 lakh

This allocation is in line with the family’s risk taking ability. They can consider

diversifying away from debt and equity into alternate assets such as managed futures,

gold and private equity. The allocation of such assets can be Rs. 20 in total – drawing

Rs. 10 lakh each from current debt and equity allocation.

• They can also consider holding some of their equity holdings in the form of

structured products – up to Rs. 15 lakh. This will ensure protection against drastic fall

in equity markets in next 2-3 years.

• The fixed deposits can be moved into more tax efficient instruments such as fixed

maturity plans and long tenor bonds such as those issued by NABARD and PSU

banks.

Risk management

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• Dr Asmita should think through the general insurance cover required for her clinic if

she decides to continue using it. Else, she should urge her colleagues in the new center

to take comprehensive cover for the property and equipment in the clinic

• Dr Asmita should consider taking professional indemnity cover to protect from

financial losses arising out of her work (e.g. liabilities from a patient suing her)

• The life insurance cover that both Dr Asmita and Prof Gokhale have is sufficient;

especially considering their present stock of liquid assets.

• The entire family should be covered with general medical insurance and critical

illness insurance.

• Dr Asmita should consider the risk to her income arising out of the shift into the new

center. She can postpone renting out the present clinic premises for a period of 3

months to make sure she is prepared for reversing her decision if need be.

Milestones

• The family has sufficient funds for meeting all the milestones. They should however

carefully create asset pools for each milestone. The planned educational trust would

already account for one such pool. Besides, they should create a separate asset pool

for their retirement corpus and for their son’s higher education.

The retirement corpus planned should incorporate the impact of inflation in post

retirement years on the corpus requirement. For a monthly income of Rs. 1 lakh after

retirement they should have a corpus generating Rs. 1.5 lakh of which Rs. 50,000 can

be reinvested in the corpus to provide for inflation in later years.

Case study: Retiree

Mr. Tarun Malhotra (65 years)

Ms. Anuradha (60 years)

Present assets

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• Cash in bank: Rs. 18 lakh

• Fixed Deposits (FD): Rs. 21 lakh

• Own house: Rs. 80 lakh

• Post office schemes: Rs. 4 lakh

• Plots of land in Delhi: Rs. 18 lakh

• Private Equity (PE) fund: Rs. 12 lakh

• Equity mutual funds: Rs. 1 lakh

Milestones

The couple is looking to use their existing holdings to have a comfortable retired life.

Their lifestyle spend is Rs. 35,000 per month. They are evaluating the option of

spending on 2-3 foreign vacations in next 5 years each costing Rs. 3 lakh.

They are also keen on bequeathing their wealth to their two granddaughters in equal

share. Retirement planning and portfolio building

• The income requirement of Rs. 4.2 lakh per year in the current year requires Rs. 90

lakh when budgeted for inflation in the next 20-25 years.

• The existing assets add up to Rs. 74 lakh excluding the primary residence. This is

unlikely to be sufficient when considered for the income requirement. The options for

the couple include the following

• Reduce the income required per month to Rs. 30,000/-

• Take out a reverse mortgage on their primary residence after next 8-10 years

• The current portfolio allocation is grossly inappropriate for retirement planning.

Following issues exist.

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• As much as Rs. 30 lakh out of the total investible assets of Rs. 74 lakh are in illiquid

holdings and are not generating any income. This needs to be converted into income

generating assets such as commercial property or monthly income plans

• The private equity allocation is too aggressive for this portfolio. It should be

reallocated to direct equities and debt at the first possible exit from the PE fund.

• As noted above, the land holdings should be converted into commercial property or a

rental yield based REIT.

• At an aggregate level the portfolio needs to have two components

• Income generating portion which at 8% can generate Rs. 35,000 per month in the

present year. This amounts to Rs. 45 lakh.

• Inflation linked portion which keeps adding to the income generating portion every

year an amount sufficient to increase its returns to the inflation adjusted value of Rs.

35,000/- in that year

Risk management

• The couple should take senior citizen’s health insurance and critical illness cover.

There is no need to take any life insurance. They should also insure their property.

• A crucial risk that the couple should watch out for over the next few years is the

longevity risk i.e. the likelihood that their lifespan is longer than the time for which

their assets last. This may be important especially in the years in which the inflation

linked portion of their portfolio has negative or very low returns.

Milestones

• The couple will find it difficult to go for their foreign vacations unless they are ready

to reverse mortgage their property in the near future.

• They should prepare a will to effectively transfer their assets to their granddaughters.

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CHAPTER XI: CONCLUSION

There is no exact definition to the term “Hedge Fund”; it is perhaps undefined in any

securities laws. There is neither an industry wide definition nor a universal meaning

for “Hedge Fund”. 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.

The term “hedge funds”, first came into use in the 1950s to describe any investment

fund that used incentive fees, short selling, and leverage. Over time, hedge funds

began to diversify their investment portfolios to include other financial instruments

and engage in a wider variety of investment strategies. However, hedge funds today

may or may not utilize the hedging and arbitrage strategies that hedge funds

historically employed, and many engage in relatively traditional, long only equity

strategies.

Other unregistered investment pools, such as venture capital funds, private equity

funds and commodity pools, are sometimes referred to as hedge funds. Although all of

these investment vehicles are similar in that they accept investors’ money and

generally invest it on a collective basis, they also have characteristics that distinguish

them from hedge funds. Hedge Fund Investment strategies tend to be quite different

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from those followed by traditional asset managers. Moreover, each fund usually

follows its own proprietary strategies.

Hedge funds have attracted significant capital over the last decade, triggered by

successful track records. The global hedge funds volume has increased from US $ 50

billion in 1988 to US $ 750 billion in 2003 yielding an astonishing cumulative average

growth rate (CAGR) of 24 %. The global hedge f und volume accounts for about 1%

of the combined global equity and bond market. Hedge funds are a growing segment

of asset management industry and increasingly becoming popular not only with high

net worth individual investors but also with institutional investors including university

funds, pension funds, insurance and endowments. Hedge funds are sometimes

perceived to be speculative and volatile. However, not all funds exhibit such

characteristics.

Hedge funds can provide benefits to financial markets by contributing to market

efficiency and enhancing liquidity. They often assume risks by serving as ready

counter parties to entities that wish to hedge risks. Hedge fund can also serve as an

important risk management tool for investors by providing valuable portfolio

diversification.

Some jurisdictions are gradually moving towards allowing the marketing of hedge

fund and fund of funds products to retail investors. Those jurisdictions have

simultaneously imposed disclosure requirements to ensure that investors understand

the complexity and associated risk of investing in hedge funds. Realizing the growing

importance of hedge funds, several emerging market regulators have opened their

markets to offshore hedge funds by providing authorization as registered foreign

investors.

The role played by some of the large hedge funds has often been associated with

major financial crisis that took place in the 90’s. However, subsequent research could

not produce robust evidence implicating the hedge funds for precipitating the crisis.

Researchers have, however, attributed the negative public perception of the role of

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hedge fund managers in crisis partly to the limited information available about what

they actually do.

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. The approach adopted in

formulating the policy suggestions put forth in Section IV of this report has been that

of transparent and regulated access with abundant caution. The suggestions are

intended to widen the FII window to allow these alternatives invest pools to our

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. The alternative invests pools if allowed to investment in Indian

markets will be a source of additional liquidity and will also diversify the pool of

foreign investments in Indian market.

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References

Websites

http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555

http://www.isb.edu/events/industry-events/hedge-fund-industry-trends-and-careers

http://tejas.iimb.ac.in/interviews/37.php#qn-8

http://www.svtuition.org/2010/05/list-of-hedge-funds-in-india.html

http://www.karvywealth.com/wealth-management-case-studies/

Books

Hedge Funds De Mystified – Frush

Hedge Fund Market Wizards: How Winning Traders Win - Jack D. Schwager

A Study on Feasibility of Introducing Hedge Funds in India - Vishnu Gorantala

Bhoopal

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