A V Rajwade: The future of hedge funds

WORLD MONEY

A spate of regulatory activism has been noticed recently in respect of the hitherto completely unregulated hedge fund industry "" it now manages almost a trillion dollars of investments spread over an estimated 7,000 funds.

Considering that the hedge fund industry is known for leveraging, it does seem to have reached a size that is capable of posing a systemic risk to financial markets. In recent weeks:

Securities and Exchange Board of India has registered a couple of hedge funds as foreign institutional investors in the equity market, after serious deliberation;

The Financial Stability Forum (FSF) that met in Washington on September 8 and 9, reviewed "developments with respect to hedge funds". FSF itself was formed under the auspices of the Bank for International Settlements, Basle, in response to the systemic risk posed by the collapse in 1998 of Long-Term Capital Management (LTCM), a US hedge fund with impeccable pedigree.

The Securities Exchange Commission (SEC) in the US had given a deadline of September 15 for receiving comments on its proposal to make it compulsory for hedge funds to register with itself. The proposal is bitterly opposed by the industry and split the commission 3-2 at the time of its adoption.

The hedge fund industry has always attracted strong criticism "" in 1992 it was accused of "breaking the Bank of England" by speculating against the pound, leading to its ignominious withdrawal from the European exchange rate mechanism.

Five years later, Mahathir Mahammed, the then Prime Minister of Malaysia, accused hedge fund managers of triggering the south-east Asian currency crisis. (Lately, however, they do not seem as active in the forex market.)

Hedge funds also have their defenders, Alan Greenspan being the most weighty of them. To quote him, "hedge funds [have become] major contributors to the flexibility of our financial system, a development that proved essential to our ability to absorb so many economic shocks in recent years."

The reason hedge funds play a useful role is that they often act as contrarians, supporting a stock when there are no buyers for it, for instance.

Originally, hedge funds were investment vehicles for wealthy individuals popular in the US. Lately, such funds are gaining increasing acceptance amongst European and Japanese investors as well. The funds are privately placed, minimum subscription often being in seven digit dollars.

Hedge funds have been in existence for the past 50 years. The name came into being as they were operating on a "hedged" basis and their results were, thus, independent of market movements.

For instance, a fund specialising in precious metals may "short", say, (overpriced) silver and simultaneously buy an equal amount of, say, (underpriced) gold.

The bracketed terms, "overpriced" and "underpriced", refer to the relative, not absolute, ruling prices of gold and silver in comparison with their historical relationship.

The objective of the two trades is to make a profit when the price relationship reverts to normal levels. Thus, the results of the investment portfolio are independent of whether precious metal prices rise or fall.

Similar examples from other markets would be:

shorting, say, corporate AAA bonds, buying government bonds (results independent of interest rate movement)

shorting, say, some software stocks, buying others (results independent of general movements of prices of stocks in the software industry).

Over the years, hedge funds have gone on to take outright leveraged positions in the currency, bond, equity, commodity and derivatives markets and justified much higher management fees, typically 15 to 20 per cent of the profits, besides a small charge as a percentage of the funds under management.

The past two years have witnessed major changes in the industry "" both on fund management and investor sides. In an earlier era, hedge funds used to be managed proprietarily by legends such as George Soros and others of his ilk.

More recently, commercial and investment banks are getting involved, thus institutionalising the industry. A corollary of such institutionalisation is, of course, a lower risk profile for an industry that has always thrived in high risk: high reward management cultures.

On the investor side, conservative investors like insurance companies and pension funds, even university endowments and foundations, are comfortable enough with the industry to put a portion of their investible funds into such speculative or, to use the more polite if euphemistic term, alternate investment strategies.

Institutional investors had about $ 65 billion invested in hedge funds at the end of last year. This is expected to quadruple over the next four years.

Even geographically, the investor base that was entirely US centric, has now spread to Europe and the far east.

The industry has also become a profitable customer segment for the major international commercial and investment banks that provide "prime broking" services "" accounting, back office, stock and fund-lending services and so on. Given that the active fund-management style means hedge funds often account for a fourth or a fifth of the total stock market activity, the fee earning potential is huge.

But will the success and growth of the industry lead to its losing its distinctive character? Quite possible "" the large number of funds and their size imply that potentially profitable mispricings will be arbitraged out as soon as they arise, thus lowering return. The industry may find it difficult to justify the huge fees its fund managers have been used to.

Email: avrco@vsnl.com