Ashok Banerjee, Ph.D., is Professor, Finance and Control, Indian Institute of Management Calcutta (IIM-C). He is also the faculty in-charge of the Financial Research and Trading Lab at IIM-C. His primary research interests are in areas of Financial Time Series, News Analytics and Mergers & Acquisitions. *Bobbur Abhilash Chowdary is a doctoral student in Finance and Control Department of IIM, Calcutta.

Hedge fund industry is drawing media attention in India. Recently Avendus Capital has reported as the first domestic hedge fund to have $1 billion asset under management.[1] A hedge fund is an alternative investment fund (AIF), which employs diverse or complex trading strategies and invests and trades in securities having diverse risks or complex products including listed and unlisted derivatives.[2] AIFs are classified into three broad categories. While category I AIF includes Angel, venture capital, social and infrastructure funds, category II includes private equity, real estate, distressed and PIPE funds. Hedge funds are classified as category III AIFs as per SEBI regulations.  There are currently 346 AIFs registered with SEBI. The Indian income tax law is not very supportive of AIFs; particularly for hedge funds. Income accruing to category I and category II AIFs, registered with SEBI, is taxed at the investor and not at the fund level.  However, category III AIFs are not accorded pass through status.  In other words, any income or gain of category III AIFs is taxed at the fund level. This is contrary to the taxation on mutual funds, where tax is charged at investors’ level. This provision leads to increase in the operating costs of hedge funds. In fact, hedge funds are not clearly defined in the income tax laws in India. If any AIF, irrespective of category, suffers a loss, such loss has to be absorbed at the fund level and cannot be passed on to the investors. This is quite a punitive provision and calls for review. Like income or gains, losses should be given pass through status.

High net worth individuals and institutional investors are allowed to invest in risky AIFs. Each scheme of AIF should have a minimum corpus of Rs. 200 million and the minimum investment amount by any investor is pegged at Rs.10 million.   Private equity (PE) and venture capital (VC) are the most popular AIF followed by real estate funds; hedge funds come as distant fourth.[3] Alternative Assets under management in India is very small compared to USA ($2.8 trillion), UK ($495 billion and China ($265 billion). However, the Indian market has huge growth potential- it grew by 55% in 2017.

There are several important differences between hedge funds and PE (and similarly VC) funds. Managers of hedge funds have flexibility to buy or sell a wide range of assets. PEs can hold long only portfolios. Hedge funds can take leverage positions, which PE cannot. Hedge funds normally seek to make profits from market inefficiencies (mispricing), rather than purely relying on economic growth to drive returns. While hedge funds have low holding period (sometimes even intraday), PEs have much longer holding period (5-7 years). Managers of hedge funds are pure financial investors, whereas PE investment comes with some degree of operational control on the investee company. Since investment horizon for hedge funds is relatively short, performance of such funds is estimated on monthly/quarterly basis. PE funds see returns only after 5-7 years.  Private equity investors simply cannot withdraw capital before the end of a fund’s life.

Investment Strategies

The returns of a hedge fund depend on the manager’s skill, as well as on market conditions. The source of returns (skill vs. market) varies significantly depending on the investment strategies adopted by hedge funds. Broadly, investment strategies of hedge funds include directional and market neutral strategies. Directional investment strategies aim to capture market trend (going long during uptrend and short during downtrend) and market neutral strategies seek to generate absolute returns independent of market conditions.  Successful hedge fund managers generate alternative beta and skill alpha. While the traditional sources of beta are the stock market spreads (for equity assets), alternative sources of beta are liquidity, volatility, beta of commodity markets etc. Similarly, structural alpha is driven by regulatory advantage that hedge funds enjoy and the latitude offered by having no benchmark. Alpha linked to the manager’s skill (ability to pick right assets at the right time) is known as skill alpha.

Common investment strategies followed by hedge funds are listed below:

Directional Strategy: This strategy seeks to take advantage of major market trends rather than trends observed in individual stocks. Managed futures and global macro strategies are two examples of directional investment strategies. Managed futures refers to taking a bet on the forward curves of futures contract. If a near-month futures contract is over-priced compared to a far-month futures contract on the same underlying asset, one may short the near-month contract and go long the far month contract. Global macro strategies apply macroeconomic views to global markets to decide entry/exit strategies. Instead of analysing macroeconomic events affecting companies or assets, they view the world from a top-down perspective (e.g., a manager taking a pessimistic view on UK currency, GBP vis-à-vis US dollar weeks before the referendum on Brexit and shorting GBP).

Long Bias and Short Bias: A fund with long bias strategy takes mostly long positions on the market. On the other hand a fund with Short bias strategy takes mostly short positions.  Long (short) bias also includes net long (short) portfolios. Typically long (short) bias indicates bullish (bearish) view about the underlying asset.

Arbitrage Relative Value: This strategy involves simultaneous buying and selling of two closely related securities whose prices have diverged “relative” to each other. Typically these securities are very highly correlated. Both the securities could be from one asset class (e.g. equity, debt, futures, options etc.) or multiple asset classes. This strategy has potential to generate returns even when the market is moving sideways. One popular example of relative value arbitrage strategy is pairs trading.

Fundamental: In this strategy a fund manager takes fundamental factors, which affect the security returns, into consideration in making investment decisions.

Bottom Up: A strategy in which fund starts with analysis of specific securities and later on move on to industry and other macro analysis.

Top Down/Macro: This is exact opposite of Bottom Up approach. In this strategy the fund manager starts off with macro analysis and then slowly moves onto analysis of specific securities.

Opportunistic: In this strategy a fund manager opportunistically employs one or more strategies which he believes can generate the best return for that asset class    

Systemic Quant: When a fund manager uses algorithms to evaluate the market, the fund is said to follow Systemic Quant strategy.  Managers typically use price, volume, volatility and liquidity information to develop quant strategies.   

Performance

The five-year (2013-2017) average performance of hedge funds in India was better than performance in many other countries (table 1). Indian hedge funds reported an average annualised return of 18%. The average monthly returns of hedge fund in India were even higher in comparison to the performance of ETFs. ETFs generated lower return with greater risk, thereby reporting a lower sharp ratio. It is important to note here that fund performance should not be judged by returns alone- one should rather look at risk-adjusted returns. Indian hedge funds have generated better returns at greater risk (standard deviation of returns) with higher drawdowns. One may argue that hedge funds in India have still outperformed (on risk-adjusted basis) Europe and USA. Within country, hedge fund has higher risk-adjusted return (mean return divided by standard deviation) than ETFs.  Since hedge funds normally generate absolute returns, there is no need to compare their performance with any benchmark.

Table 1: Average Performance of Hedge Fund Industry

Source: Thompson Reuters Lipper. Authors’ calculations

Different investment strategies provide mixed results. While the systematic quant strategy reported highest average returns (table 2), it comes at a greater risk. The directional strategies, on the other hand, have minimum downside risk and lower standard deviation.  Surprisingly, short bias has performed better than long bias strategy with positive returns in seventy five per cent of months.

Table 2:  Strategy-wise Performance

Source: Thompson Reuters Lipper. Authors’ calculations

There has been consistent decline in the number of strategies adopted by hedge fund managers in India over the past five years (table 3). One can observe maximum decline in relative value arbitrage strategies, followed by long bias strategies. It does not necessarily mean that Indian financial markets have been bearish during the period 2013-17. One has to look at the asset under management under each strategy to draw any conclusions about investors’ preferred strategies. Investment strategies based on fundamental information has been consistent throughout the observed period.

Table 3: Investment Strategies during the year

Source: Thompson Reuters Lipper. Authors’ calculations. Each strategy is assumed to liquidate at the end of the month.

The asset under management has increased over the past five years (table 4) with maximum investment in long bias strategies in 2017. There has been a decline in investments under relative value strategies. Investment exposure to fundamental strategies has doubled over the past five years. When one compares fund performance with AUM, one may note that long bias did continue to attract large funds despite not so noteworthy performance.  It implies that AUMs are not necessarily based on historical performance.

Table 4: Asset Under Management (AUM)

Source: Thompson Reuters Lipper. Authors’ calculations (figs in INR million)

Hedge funds, as an alternative asset class, has potential to grow. However, activities of hedge funds need to be carefully monitored without stifling its growth potential. Hedge funds do indulge in proprietary trading at high frequency and this is an area presently under close scrutiny of market regulators.  Regulators believe that high frequency traders abuse their advantage of ‘speed trade’ and adversely affect market quality. However, empirical finds about the role of high frequency traders is mixed.

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[1] Times of India, 25 January 2018

[2] SEBI (Alternative Investment Funds) Regulations 2012

[3] As of December 2016 Asset under management (AUM) of PE and VC funds was $23.6bn, followed by real estate funds $10.2 bn; and hedge funds comes fourth with AUM of $1.4 bn. (Source: Preqin Insight Report, November 2017)