Hedge funds worry India
By Indrajit Basu
KOLKATA - As if a typical monsoon had struck India, the sky over the Mumbai head office of Mastek Ltd, which claims to be the first IT solutions company in the world to be assessed at top levels for its software processes, was dull and gray on the morning of July 15. Inside, it was equally gloomy, for different reasons.
Mastek's stock price had fallen 33 percent immediately on the opening of the market, following disappointing results the previous evening. Fourth-quarter profits and revenues had plunged by 81 percent and 7 percent respectively, and the company had issued an equally grim profit warning. But, while Mastek senior officials huddled in their offices that afternoon, unavailable to the media, stock market sources smelt a rat - hedge funds.
There is no direct evidence that hedge funds were involved in the dramatic fall in Mastek's share price. Indeed, the company's steep slide was partly justified on the basis of its results and the profit warning. However, global hedge funds, with their quick forays in and out of markets in search of total returns, have been at play in India over the past several months, to dramatic effect.
Girish Nadkarni of TAIB Securities and other equities brokers and analysts said they suspect that somebody large was trying to tip the market against Mastek and Indian tech stocks in general, "and that force could be well be a hedge fund. After all, hedge funds applied similar tactics on Infosys four months back and succeeded," said Nilangshu Joshi, an independent operator.
Even as a surge of inflows from foreign institutional investors (FIIs) are helping Indian stock markets touch new highs almost every day, a certain nervousness is looming over the country's capital markets.
"Although big FIIs have been investing in India actively this year, hedge funds have also been active. What makes the market nervous is the prospect of these hedge funds booking profits before the earnings season kicks off," said S Sreesankar, a prominent stock market analyst.
Hedge funds are increasingly emerging as India as well as globally as investment playthings for the super-rich (see Hedge funds beat the odds - for some as significant forces in recent months. They have become a cause for concern not only for the country’s stock markets but also the Securities and Exchange Board of India, (SEBI), the regulating authority. Of the Rs 101 billion (US$2.2 billion) of FII money that had flowed into India this year by July – the highest inflow in recent times - over $1 billion is from hedge funds, stockbrokers say.
"Around 40 to 50 percent of the overseas money flowing into the Indian market is through participatory notes and most of it is coming from hedge funds," said Dharmesh Mehta, head of equities with Enam Securities.
Hedge funds make their money by identifying imperfections around the globe in the price of financial assets - equities, bonds or currencies. They typically require a minimum investment of US$500,000, making them available only to institutional investors and the very wealthy. They typically have lock-in periods ranging up to five years. Most require net worth on the part of investors ranging from $1 million to $5 million.
Unlike traditional mutual funds, they rarely buy and hold. Their basic goal is to zip in and out of positions, often powered by borrowed money. They could, for instance, go long on a company in the US (like Infosys) and short it in India. If the strategy works, then they make money both ways. They will go aggressively after anything and everything that moves.
India has emerged an ideal operating ground following SEBI's permission in December last year to allow foreign institutional investors to invest in equity derivatives, a nascent market in which local punters have not developed the skills to take full advantage. The market's immaturity thus offers skilled traders opportunities to book quick, short-term gains, and market imperfections and arbitrage opportunities are essentially what hedge funds look for to make a killing.
It is this nature of hedge funds that keep regulators and stock markets around the world worried; it is almost impossible to keep them in check. They tend to increase market volatility. Occasionally they can even cause an entire economy to crack under the weight of their selling. That is the biggest reason behind SEBI's discomfort. Experts say emerging markets and India in particular, are hot and hedge funds are going full out to capture returns. Over the last 18 months, hedge funds have gone on overdrive across the world, delivering average returns of 12 percent.
Emerging markets hedge funds have done even better, delivering two-year and three-year returns of 20 percent and 14 percent respectively while the S&P 500 - the benchmark index in the United States - has fallen by 27 percent and 38 percent respectively. The last 18 months have also seen a spate of new hedge fund start-ups entering the market. There are now at least 55 hedge funds focusing purely on Asia and hundreds of funds that have allocations to Asian stocks, debt or currencies.
Global hedge fund capital under management now totals $650 billion - up from just $50 billion in 1990. The exponential growth has been driven by investors who have grown tired of giving their savings to mutual funds, which are happy if they outperform their benchmark indices even on the way down. Some US$7 trillion in market capitalization was wiped out in the market collapse that began 2000. Secondly, interest rates have also steadily declined across the world, thus making investors who preferred debt to look for new parking places.
Hedge funds, with their focus on absolute positive returns, thus emerge as favorites because unlike mutual funds, they make money only if investors do. They usually aren't paid unless they generate returns. Third, and more importantly, developments in the US are also making the new US hedge funds look outwards at alternate investment destinations. The most compelling one is a registration requirement late last year that requires US offshore funds to register with the US Treasury Department's Financial Crimes Enforcement Network. The new norms apply to hedge funds with US clients, are organized and/or sponsored by US citizens and have investments exceeding $1 million.
This essentially means that the new norms apply to all large hedge funds promoted by US nationals. It also means that US offshore funds, which have been routing investments through known tax havens like Mauritius to invest in India and other emerging markets, would now be subject to the US Treasury's scrutiny. All hedge funds, according to brokers, have chosen to operate in India indirectly (using an instrument called participatory notes which is are nothing but contracts issued by foreign and Indian broker outfits that are registered with SEBI), because SEBI has always frowned on the prospect of hedge funds entering the Indian market and has refused to register them.
Equity investors believe that almost all the large foreign brokerages like Credit Lyonnais, Merrill Lynch, Morgan Stanley and Salomon Smith Barney issue participatory notes. Sources add that other institutions (non-FIIs) and Indian brokers also offer this service to hedge funds. Which is why, although hedge funds have scared many, many Indian and foreign brokerage houses have started lobbying with SEBI and the Finance Ministry to officially open doors to pure US hedge funds.
"India has set itself a target of US$5 billion of foreign investment inflows during the fiscal year 2003-04," said Arvind Mahajan, a Kolkata-based broker. "And to achieve that, the country will have to open up to newer sources, hedge funds included."
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