India: A Case For Domestic Hedge Funds In India?

Last Updated: 1 October 2008
Article by Chetan Nagendra

A few months back, I had the opportunity to read V. Umakanth's working paper on hedge fund regulation in India (available on Mondaq and Hedge Fund Law Review). Umakanth, in his paper sets out a framework for banking and capital market regulators, the RBI and SEBI respectively, to regulate offshore hedge funds using a variety of mechanisms- prohibition, disclosure, registration and regulatory. My general comment on the article was that the author is advocating regulation even before an industry takes off.

Fast forward to the current- Lehman's bankrupt, Goldman Sachs and Morgan Stanley have converted into banks, a $700 Billion bailout is in the offing, short selling is being banned systematically from the US to Austria and US Secretary Paulson has had to make unprecedented TV appearances to calm markets. Of course, personal appearances are nothing new in India where the finance minister regularly steps in to make statements for "pacifying" markets, or the market regulator steps in with "orders" to "stabilize" the market from "FII movements".

Despite the calming messages by the Indian banking and capital market regulators to try and subvert the regular market mayhem that has been a regular feature of the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), local investors are often at a loss to understand:

  1. why markets regularly see-saw by a couple of thousand points at every influx or adverse stock movements by foreign institutional investors (FIIs), or
  2. why IPOs have all but disappeared and that the Indian markets have been terrible performers in 2008, or
  3. why the local mutual fund industry is largely fueled by cash inflows from corporates rather than investments of the general public, with the latter having a distinct preference of placing cash in deposits with government owned banks.

Some reasons include:

  1. the lack of financial innovation in Indian markets due to severe restrictions in the form of complex taxation and a multitude of regulators and legislation;
  2. retail investors being denied access to alternative investment products by a combination of high tax rates, a lack of modernity in the decades old companies legislation (it still takes more than a month to set up a company and years to wind it down), an over-reliance on federal policies to determine the course of corporate growth in states, and complex bureaucratic procedures on the road to investing. On the other hand, foreign institutional investors have access to Indian stock markets, which to these investors, is an alternative investment class in itself;
  3. Indian regulators allowing Qualified Institutional Buyers (QIBs) to gain sequentially and substantially in primary market offerings but does this category of a sophisticated investor need regulatory encouragement in the first place?

These long-standing distortions have resulted in a scenario where the most aggressive, legitimate, retail investors are limited to investing in quasi-insurance or mutual fund schemes with (a) plain vanilla equity or fixed income focus or (b) sectoral focus. You got the math right- very few choices for a country of a billion.

The regulators should concentrate on broad basing Indian capital markets.

The 10 lakh rupee question is when offshore funds can invest in the Indian markets, shouldn't the regulators make it conducive for entrepreneurs to set-up domestic funds to tap domestic investors completely? Tax-breaks or acknowledgement of pass-through structures for tax purposes would certainly help the industry.

There is definitely a case in favor of creating alternative investments to sophisticated investors in India. Advantages include (a) investors opting for appropriate risk-reward scheme(s) that suit their individual needs; (b) primary markets not necessarily drying up each time the United States catches the flu; and, (c) domestic hedge funds would force the growth of a healthy disclosure culture (thanks to the much-maligned short sellers).

In fact the majority of the offshore funds investing in India are guaranteed to have a very healthy mix of sophisticated resident US and offshore investors. Sophisticated investors rarely like being "commoditized" and it all boils down to a choice between choosing a reputable fund manager to manage assets or to go with the rest of the flock and invest with licensed fund houses.

As you guessed, it is a problem of choice. In India, the choice doesn't exist, yet.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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