Who's afraid of hedge funds?

Indian financial regulators get skittish when the word "hedge fund" is used. Recent announcements suggest some movement by Sebi and the ministry of finance in their favour, while the RBI continues to argue against. One source of fear of hedge funds is the notion that all hedge funds act in concert. However, the global hedge fund industry is highly competitive. Over $1 trillion is managed by more than 8,000 hedge funds, each of which fights to gain an edge over the others. Coordination between such a large number of adversarial entities is impossible. Though a herd mentality can set in, on any given day some hedge funds will buy and some hedge funds sell.

The customers of hedge funds are institutions and sophisticated individuals. They have the wherewithal to monitor hedge funds, and shift assets to the best return-to-risk ratio. They keep the hedge fund manager on his toes. Marketing gimmicks targeting retail investors can put money into the hands of an incompetent manager. Such gimmicks do not work in the hedge fund sector, which is meritocratic and performance-driven. Fearful third world regulators like the RBI harp on the LTCM episode of 1999. Just as one plane crash does not render all plane travel useless, the case for hedge funds is not invalidated by one problem. The recent demise of Amaranth""where losses bigger than LTCM took place""shows improving institutional structures. From a regulatory viewpoint, Amaranth was a pleasant episode. A few rich men lost money, while hedge funds as a whole continued to trade every day, making markets more efficient.

There are two alternative strategies for regulation. On the one hand is the US path, where the government is not involved in the relationship between the hedge fund and his customer. Alternatively, in the UK and in Scandinavia, there is some light-touch regulation. In either case, the activities of hedge funds in securities markets have to comply with all margin requirements, position limits, etc. In India, given the penchant for turning a whiff of regulation into an onerous licence-permit raj, the US route would be better. A US-style policy framework needs to be created, to support both foreign and domestic hedge funds.

The international consensus today says that hedge funds engage in rational trades and supply liquidity. The smartest analytical financial economics, the best Ph.D.s, and the best computer technology for trading are now in the hands of hedge funds. India needs their risk-taking, their liquidity provision, their analytical minds, and their systems. Foreign hedge funds are useful since they would not get shaken by the ups and downs of the market in the way that local investors do.

On the interest rate and currency markets, India has failed to build meaningful markets; the active and intelligent trading of hedge funds can induce a paradigm shift. On the equity market also, the volatility of May 2006 has given a drop in liquidity which has still not been erased. Monthly traded volumes in equity spot and derivatives markets have dropped sharply. The gutsy retail liquidity providers of India have been shaken by the volatility of May 2006. Globally diversified hedge funds are a useful source of liquidity provision in Indian financial markets.