Hedge Funds

CHAPTER I: INTRODUCTION
The term 'hedge fund' is used to describe a wide variety of institutional investors
employing a diverse set of investment strategies. Although there is no formal
definition of 'hedge fund,' hedge funds are largely defined by what they are not and by
the regulations to which they are not subject. As a general matter, the term 'hedge
fund' refers to unregistered, private investment partnerships for wealthy sophisticated
investors (both natural persons and institutions) that use some form of leverage to
carry out their investment strategies.
The term 'hedge fund' is undefined, including in the federal securities laws. Indeed,
there is no commonly accepted universal meaning. As hedge funds have gained stature
and prominence, though, 'hedge fund' has developed into a catch-all classification for
many unregistered privately managed pools of capital. These pools of capital may or
may not utilize the sophisticated hedging and arbitrage strategies that traditional hedge
funds employ, and many appear to engage in relatively simple equity strategies.
Basically, many 'hedge funds' are not actually hedged, and the term has become a
misnomer in many cases.
Hedge funds engage in a variety of investment activities. They cater to sophisticated
investors and are not subject to the regulations that apply to mutual funds geared
toward the general public. Fund managers are compensated on the basis of
performance rather than as a fixed percentage of assets. 'Performance funds' would be
a more accurate description.

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CHAPTER II
Objective of the study:

To understand the meaning & characteristics of Hedge Funds

To understand the growth & future prospects of Hedge Funds
To understand the working of a Hedge Funds
To know the benefits of Hedge Funds
To understand the risk faced by Hedge Fund Investments & Managers
To understand the future prospects of this industry in India

Research methodology:
In order to accomplish this project successfully we will take following steps.
Data collection:
Secondary Data:
Internet, Books, newspapers, journals and books, other reports and projects, literatures

Limitations of research:
The study is limited to understanding the working of the hedge fund Industry & its
future prospects in India

CHAPTER III: CHARACTERISTICS OF HEDGE FUNDS

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Hedge funds utilize a variety of financial instruments to reduce risk, enhance

returns and minimize the correlation with equity and bond markets. Many
hedge funds are flexible in their investment options (can use short selling,
leverage, derivatives such as puts, calls, options, futures, etc.).

Hedge funds vary enormously in terms of investment returns, volatility and

risk. Many, but not all, hedge fund strategies tend to hedge against downturns
in the markets being traded.

Many hedge funds have the ability to deliver non-market correlated returns.

Many hedge funds have as an objective consistency of returns and capital

preservation rather than magnitude of returns.

Most hedge funds are managed by experienced investment professionals who

are generally disciplined and diligent.

Pension funds, endowments, insurance companies, private banks and high net
worth individuals and families invest in hedge funds to minimize overall
portfolio volatility and enhance returns.

Most hedge fund managers are highly specialized and trade only within their
area of expertise and competitive advantage.

Hedge funds benefit by heavily weighting hedge fund managers remuneration

towards performance incentives, thus attracting the best brains in the
investment business. In addition, hedge fund managers usually have their own
money invested in their fund.

Facts about the Hedge Fund Industry

Estimated to be a $1 trillion industry and growing at about 20% per year with
approximately 8350 active hedge funds.

Includes a variety of investment strategies, some of which use leverage and

derivatives while others are more conservative and employ little or no leverage.
Many hedge fund strategies seek to reduce market risk specifically by shorting
equities or through the use of derivatives.

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Most hedge funds are highly specialized, relying on the specific expertise of
the manager or management team.

Performance of many hedge fund strategies, particularly relative value

strategies, is not dependent on the direction of the bond or equity markets -unlike conventional equity or mutual funds (unit trusts), which are generally
100% exposed to market risk.

Many hedge fund strategies, particularly arbitrage strategies, are limited as to

how much capital they can successfully employ before returns diminish. As a
result, many successful hedge fund managers limit the amount of capital they
will accept.

Hedge fund managers are generally highly professional, disciplined and

diligent.

Their returns over a sustained period of time have outperformed standard

equity and bond indexes with less volatility and less risk of loss than equities.

Beyond the averages, there are some truly outstanding performers.

Investing in hedge funds tends to be favored by more sophisticated investors,

including many Swiss and other private banks that have lived through, and
understand the consequences of, major stock market corrections.

An increasing number of endowments and pension funds allocate assets to

hedge funds.

CHAPTER IV: GROWTH OF HEDGE FUNDS

In the entire financial services area, the sector showing the most growth is clearly the
area of hedge funds. While brokerage commissions continue to decline, investment
banking fees start to come under pressure and the entire financial services industry
worries about intensified regulatory scrutiny, the hedge fund industry with its rapid
growth stands out from the crowd. New funds are starting up every week and many
are beginning with an excess of a billion dollars under management from day one. The
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amount of money under management with hedge funds has gone up four times
between 1996 and 2004 and is expected to further triple between now and 2010 to
over $2.7 trillion. Public funds, endowments, and corporate sponsors have all
increased their allocations to hedge funds within the context of an increased allocation
towards alternative investments more generally. This move towards increased
investments in real estate/private equity/hedge funds (alternative investments) is
driven by the need for a higher return to compensate for the expected lower returns
from more conventional investment strategies focused on US bonds and equities.
There is also a clear desire among this investor base to be more focused on absolutereturn strategies rather than relative return. Given the current level of allocations most
of these large long-term investors have towards alternative investments, and their
professed long-term target allocation, the flow of funds to these asset classes will
remain strong.
One of the intriguing developments in the hedge fund world is the clear desire
and ability of the newer funds to charge higher fees and impose more stringent terms
on investors. No longer are funds charging a 1 per cent management fee and 20 per
cent of profits -- the norm for the first generation of funds set up in the early to mid
1990s. As per an interesting study done by Morgan Stanley's prime brokerage unit,
about a third of the funds opening in the past six months are charging a 2 per cent
management fee and 20 per cent of profits or higher, while the majority are charging a
1.5 per cent management fee and 20 per cent of profits. Many of the new funds have
more stringent lock-ups and stiff penalties if you redeem early, as well as modified
high-water marks.
The hedge fund business thus seems to have the unique characteristic of being
possibly the only business that I know of wherein new players (most of whom are
unproven) have the ability to charge more and get better terms than the established
operators. This implies a negative franchise value for the established large fund
complexes which have survived and prospered through the years. Given that most of
the best hedge fund complexes are closed to new investors, the new guys seem to be
taking advantage of the huge demand-supply mismatch for quality money managers.
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There is a feeding frenzy currently under way in the world of alternative investments
and clients are paying up the higher fees for fear of being locked out from these funds
at a later date, if they actually survive and grow.
One reason why the new boys are focusing more on fees and lock-ups could be the
difficulty all hedge funds are having in generating adequate alpha (excess return) to
ensure an adequate payout for themselves.
In a study done by Morgan Stanley on the excess returns generated by hedge
funds over the last decade, this trend of declining returns was very apparent. In the
study they defined excess returns as the return of the Hedge Fund research composite
over one month LIBOR (a proxy for cash returns).
In the 1995-97 period, excess returns were 14 per cent; these returns have
consistently declined dropping to as low as 5 per cent in 2001-03 and have dropped
further since.
The current huge inflows into funds focused on emerging markets make sense if
you look at performance numbers over the past three years.
Hedge funds focused on the emerging markets had the best returns with an 18
per cent annual return during 2001-04, closely followed by distressed debt focused
funds at 17 per cent. More conventional hedge fund strategies of tech at 0 per cent and
risk arbitrage at 3 per cent annual return lagged far behind. Given the constant inflows
into new hedge funds, clients do not yet seem to be bothered about paying higher and
higher fees for lower returns, but this is a discussion that I am sure will come up at
some stage in most investment committees. At some stage if the hedge fund
community continues to show declining alpha (excess returns), clients will need to
question whether the proliferation of hedges has reduced returns because the field has
become too competitive.
The beauty of the hedge fund business and the reason why the upward drift in
fee structure is even more surprising is the ease of entry of new players into the game.
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The average long short hedge fund needs only about six back office staff per billion
dollars, while a global macro fund needs about 11 people for a fund of similar size
(Morgan Stanley survey). The typical long short US equity manager has only nine
investment professionals and three in the back office. These funds are also not really
regulated and have very limited disclosure requirements, if any. The start-up costs of
these vehicles are also minimal and most funds will be able to break even at sub $100
million in assets under management. There is no other industry that I am aware of
where exit and entry are as simple.
Hedge funds till date in 2005 have had a tough year; there have been few strong trends
to capitalize on and most funds are struggling to show a positive return. If the hedge
fund industry ends the year flat or even (god forbid) negative after disappointing
relative performance in 2003 and just about average numbers in 2004, some of the
more sophisticated clients may migrate back to more conventional forms of investing
with lower fee structures. Hedge funds are clearly here to stay, and continue to attract
the best talent because of their payout structures; however, their ability to continue to
command a premium fee structure will eventually be limited by their ability to
differentiate themselves from their long-only brethren on the performance front.

CHAPTER V: HEDGE FUND DATA

Why hedge funds are attractive?
There are a large number of investment vehicles that offer you good and stable
returns. Products like diversified mutual funds, blue chip stocks and property are some
of them. But for high net worth individuals (HNIs), there are more routes, especially
in the international markets. Here we look at one such vehicle, namely hedge funds. A
hedge fund is a common term used to describe private unregistered investment
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partnerships. Since most of them are not registered with financial regulators in their
countries of origin, they do not need to meet the eligibility requirements to register as
institutional investors. This is good in a way but could turn sour as well because there
are no guidelines binding them...
These funds are very manager-centric as the entire onus of their success or failure falls
on the fund manager's ability to exploit existing market conditions. No wonder then
that they charge a fixed fee of around 2 per cent a year of assets under management,
along with a very high profit sharing percentage, which is mostly 20 per cent. Of
course, they have to assure returns as well. Thus, profit sharing may start on the
returns over and above say, the first 10 per cent returns. The fee is also based on a
high watermarking concept, which means that the fund manager is entitled to a share
of profits the first time. Thereafter, if the fund incurs losses and then recoups, the fund
manager will not be entitled to any share of the recouped losses. The next time he will
be entitled is when he beats his earlier performance.
However, given the plethora of opportunities worldwide, the fund manager has the
luxury of making investment decisions in stocks, bonds, commodities, currencies etc.
The basic idea is to generate aggressive returns. The most important feature of hedge
funds is that they seek to deliver absolute, rather than benchmarked returns. For
example, equity mutual funds are benchmarked against an index like the Nifty or BSE
200, or a banking sector mutual fund could benchmark its returns against the banking
index on a stock exchange and can show the investors how much better/worse he has
performed. However, hedge funds managers do not have any such luxuries.
Since they are not regulated, most countries do not allow them to raise money from
the general public through a prospectus or advertisements. A few are registered with
the regulators in their countries because their main investors are universities, pension
funds and insurance companies.
Most of the marketing is done through investment advisors or personal contacts, with
their main investors being restricted to sophisticated HNIs. With the Reserve Bank of
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India (RBI) allowing Indian residents to invest up to $200,000 abroad per head a year,
it is another opportunity for HNIs to tap these funds as the minimum limit of many of
them start from $100,000. But you need to remember that the amount invested is not
very liquid and may be subject to a lock-in period, with quarterly, half-yearly or yearly
exit windows.
Those seeking to invest in hedge funds can approach a wealth manager, securities
broker or investment consultant abroad, who can advise them on the available options
and select the hedge fund they wish to invest in, based on its track record and
management style. After that they can approach their bank in India to arrange for the
foreign remittance to the hedge fund. Whenever they wish to redeem their investment,
as permitted by the hedge fund, they can repatriate the proceeds to India into their
bank account.
What information should one seek if one is considering investing in a hedge fund
or a fund of hedge funds?

Read a fund's prospectus or offering memorandum and related materials.

Make sure you understand the level of risk involved in the fund's investment
strategies and ensure that they are suitable to your personal investing goals,
time horizons, and risk tolerance. As with any investment, the higher the
potential returns, the higher the risks one must assume.

Understand how a fund's assets are valued. Funds of hedge funds and hedge
funds may invest in highly illiquid securities that may be difficult to value.
Moreover, many hedge funds give themselves significant discretion in valuing
securities. One should understand a fund's valuation process and know the
extent to which a fund's securities are valued by independent sources.

Ask questions about fees. Fees impact your return on investment. Hedge
funds typically charge an asset management fee of 1-2% of assets, plus a
performance fee of 20% of a hedge funds profit. A performance fee could
motivate a hedge fund manager to take greater risks in the hope of generating a
larger return. Funds of hedge funds typically charge a fee for managing your
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assets, and some may also include a performance fee based on profits. These
fees are charged in addition to any fees paid to the underlying hedge funds.

Understand any limitations on your right to redeem your shares. Hedge

funds typically limit opportunities to redeem, or cash in, your shares (e.g., to
four times a year), and often impose a "lock-up" period of one year or more,
during which you cannot cash in your shares.

Research the backgrounds of hedge fund managers. Know with whom you
are investing. Make sure hedge fund managers are qualified to manage your
money, and find out whether they have a disciplinary history within the
securities industry. One can get this information (and more) by reviewing the
advisers Form ADV. You can search for and view a firms Form ADV using
the SECs Investment Adviser Public Disclosure (IAPD) website. You also can
get copies of Form ADV for individual advisers and firms from the investment
adviser, the SECs Public Reference Room, or (for advisers with less than $25
million in assets under management) the state securities regulator where the
adviser's principal place of business is located. If you dont find the investment
adviser firm in the SECs IAPD database, be sure to call your state securities
regulator or search the NASD's Broker Check database for any information
they may have.

Don't be afraid to ask questions. You are entrusting your money to someone
else. You should know where your money is going, who is managing it, how it
is being invested, how you can get it back, what protections are placed on your
investment and what your rights are as an investor. In addition, you may wish
to read NASDs investor alert, which describes some of the high costs and risks
of investing in funds of hedge funds.

What protections does one have if one purchases a hedge fund?

Hedge fund investors do not receive all of the federal and state law protections that
commonly apply to most registered investments. For example, you won't get the same
level of disclosures from a hedge fund that you'll get from registered investments.
Without the disclosures that the securities laws require for most registered
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investments, it can be quite difficult to verify representations you may receive from a
hedge fund. You should also be aware that, while the SEC may conduct examinations
of any hedge fund manager that is registered as an investment adviser under the
Investment Advisers Act, the SEC and other securities regulators generally have
limited ability to check routinely on hedge fund activities.
The SEC can take action against a hedge fund that defrauds investors, and we have
brought a number of fraud cases involving hedge funds. Commonly in these cases,
hedge fund advisers misrepresented their experience and the fund's track record. Other
cases were classic "Ponzi schemes," where early investors were paid off to make the
scheme look legitimate. In some of the cases we have brought, the hedge funds sent
phony account statements to investors to camouflage the fact that their money had
been stolen. That's why it is extremely important to thoroughly check out every aspect
of any hedge fund you might consider as an investment.

Hedging Strategies
Wide ranges of hedging strategies are available to hedge funds. For example:

Selling short - selling shares without owning them, hoping to buy them back at
a future date at a lower price in the expectation that their price will drop.

Using arbitrage - seeking to exploit pricing inefficiencies between related

securities - for example, can be long convertible bonds and short the underlying
issuers equity.

Trading options or derivatives - contracts whose values are based on the

performance of any underlying financial asset, index or other investment.

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Investing in anticipation of a specific event - merger transaction, hostile

takeover, spin-off, exiting of bankruptcy proceedings, etc.

Investing in deeply discounted securities - of companies about to enter or exit

financial distress or bankruptcy, often below liquidation value.

Many of the strategies used by hedge funds benefit from being non-correlated
to the direction of equity markets

Popular Misconception
The popular misconception is that all hedge funds are volatile -- that they all use
global macro strategies and place large directional bets on stocks, currencies, bonds,
commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge
funds are global macro funds. Most hedge funds use derivatives only for hedging or
don't use derivatives at all, and many use no leverage.

CHAPTER VI: BENEFITS OF HEDGE FUNDS

Many hedge fund strategies have the ability to generate positive returns in both
rising and falling equity and bond markets.

Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk

and volatility and increases returns.

Huge variety of hedge fund investment styles many uncorrelated with each
other provides investors with a wide choice of hedge fund strategies to meet
their investment objectives.

Academic research proves hedge funds have higher returns and lower overall
risk than traditional investment funds.

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Hedge funds provide an ideal long-term investment solution, eliminating the

need to correctly time entry and exit from markets.

Adding hedge funds to an investment portfolio provides diversification not

otherwise available in traditional investing.

Hedge Fund Styles

The predictability of future results shows a strong correlation with the volatility of
each strategy. Future performance of strategies with high volatility is far less
predictable than future performance from strategies experiencing low or moderate
volatility.
Aggressive Growth: Invests in equities expected to experience acceleration in growth
of earnings per share. Generally high P/E ratios, low or no dividends; often smaller
and micro-cap stocks which are expected to experience rapid growth. Includes sector
specialist funds such as technology, banking, or biotechnology. Hedges by shorting
equities where earnings disappointment is expected or by shorting stock indexes.
Tends to be "long-biased." Expected Volatility: High
Distressed Securities: Buys equity, debt, or trade claims at deep discounts of
companies in or facing bankruptcy or reorganization. Profits from the market's lack of
understanding of the true value of the deeply discounted securities and because the
majority of institutional investors cannot own below investment grade securities. (This
selling pressure creates the deep discount.) Results generally not dependent on the
direction of the markets. Expected Volatility: Low - Moderate
Emerging Markets: Invests in equity or debt of emerging (less mature) markets that
tend to have higher inflation and volatile growth. Short selling is not permitted in
many emerging markets, and, therefore, effective hedging is often not available.
Expected Volatility: Very High
Funds of Hedge Funds: Mix and match hedge funds and other pooled investment
vehicles. This blending of different strategies and asset classes aims to provide a more
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stable long-term investment return than any of the individual funds. Returns, risk, and
volatility can be controlled by the mix of underlying strategies and funds. Capital
preservation is generally an important consideration. Volatility depends on the mix
and ratio of strategies employed. Expected Volatility: Low - Moderate - High
Income: Invests with primary focus on yield or current income rather than solely on
capital gains. May utilize leverage to buy bonds and sometimes fixed income
derivatives in order to profit from principal appreciation and interest income.
Expected Volatility: Low
Macro: Aims to profit from changes in global economies, typically brought about by
shifts in government policy that impact interest rates, in turn affecting currency, stock,
and bond markets. Participates in all major markets -- equities, bonds, currencies and
commodities -- though not always at the same time. Uses leverage and derivatives to
accentuate the impact of market moves. Utilizes hedging, but the leveraged directional
investments tend to make the largest impact on performance. Expected Volatility:
Very High
Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking
offsetting positions, often in different securities of the same issuer. For example, can
be long convertible bonds and short the underlying issuers equity. May also use
futures to hedge out interest rate risk. Focuses on obtaining returns with low or no
correlation to both the equity and bond markets. These relative value strategies include
fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and
closed-end fund arbitrage. Expected Volatility: Low
Market Neutral - Securities Hedging: Invests equally in long and short equity
portfolios generally in the same sectors of the market. Market risk is greatly reduced,
but effective stock analysis and stock picking is essential to obtaining meaningful
results. Leverage may be used to enhance returns. Usually low or no correlation to the
market. Sometimes uses market index futures to hedge out systematic (market) risk.
Relative benchmark index usually T-bills. Expected Volatility: Low
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Market Timing: Allocates assets among different asset classes depending on the
manager's view of the economic or market outlook. Portfolio emphasis may swing
widely between asset classes. Unpredictability of market movements and the difficulty
of timing entry and exit from markets add to the volatility of this strategy. Expected
Volatility: High
Opportunistic: Investment theme changes from strategy to strategy as opportunities
arise to profit from events such as IPOs, sudden price changes often caused by an
interim earnings disappointment, hostile bids, and other event-driven opportunities.
May utilize several of these investing styles at a given time and is not restricted to any
particular investment approach or asset class. Expected Volatility: Variable
Multi Strategy: Investment approach is diversified by employing various strategies
simultaneously to realize short- and long-term gains. Other strategies may include
systems trading such as trend following and various diversified technical strategies.
This style of investing allows the manager to overweight or underweight different
strategies to best capitalize on current investment opportunities. Expected Volatility:
Variable
Short Selling: Sells securities short in anticipation of being able to rebuy them at a
future date at a lower price due to the manager's assessment of the overvaluation of
the securities, or the market, or in anticipation of earnings disappointments often due
to accounting irregularities, new competition, change of management, etc. Often used
as a hedge to offset long-only portfolios and by those who feel the market is
approaching a bearish cycle. High risk. Expected Volatility: Very High
Special Situations: Invests in event-driven situations such as mergers, hostile
takeovers, reorganizations, or leveraged buyouts. May involve simultaneous purchase
of stock in companies being acquired, and the sale of stock in its acquirer, hoping to
profit from the spread between the current market price and the ultimate purchase
price of the company. May also utilize derivatives to leverage returns and to hedge out

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interest rate and/or market risk. Results generally not dependent on direction of
market. Expected Volatility: Moderate
Value: Invests in securities perceived to be selling at deep discounts to their intrinsic
or potential worth. Such securities may be out of favor or under followed by analysts.
Long-term holding, patience, and strong discipline are often required until the ultimate
value is recognized by the market. Expected Volatility: Low - Moderate
Advantages of Hedge Funds over Mutual Funds
Hedge funds are extremely flexible in their investment options because they use
financial instruments generally beyond the reach of mutual funds, which have SEC
regulations and disclosure requirements that largely prevent them from using short
selling, leverage, concentrated investments, and derivatives.
This flexibility, which includes use of hedging strategies to protect downside risk,
gives hedge funds the ability to best manage investment risks.
The strong results can be linked to performance incentives in addition to
investment flexibility. Unlike many mutual fund managers, hedge fund managers are
usually heavily invested in a significant portion of the funds they run and share the
rewards as well as risks with the investors. "Incentive fees" remunerate hedge fund
managers only when returns are positive, whereas mutual funds pay their financial
managers according to the volume of assets managed, regardless of performance. This
incentive fee structure tends to attract many of best practitioners and other financial
experts to the hedge fund industry.
In the last nine years, the number of hedge funds has risen by about 20 percent
per year and the rate of growth in hedge fund assets has been even more rapid.
Currently, there are estimated to be approximately 8350 hedge funds managing $1
trillion. While the number and size of hedge funds are small relative to mutual funds,
their growth reflects the importance of this alternative investment category for
institutional investors and wealthy individual investors.
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CHAPTER VII: WORKINGS OF HEDGE FUNDS

A hedge fund is a private investment fund charging a performance fee and typically
open to only a limited range of qualified investors. In the United States, hedge funds
are open to accredited investors only. Because of this restriction, they are usually
exempt from any direct regulation by regulatory bodies. Alfred Winslow Jones is
credited with inventing hedge funds in 1949.
As a hedge fund's investment activities are limited only by the contracts governing the
particular fund, it can make greater use of complex investment strategies such as short
selling, entering into futures, swaps and other derivative contracts and leverage.
As their name implies, hedge funds often seek to offset potential losses in the principal
markets they invest in by hedging via any number of methods. However, the term
"hedge fund" has come in modern parlance to be overused and inappropriately applied

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to any absolute-return fund many of these so-called "hedge funds" do not actually
hedge their investments.
Hedge funds have acquired a reputation for secrecy. Unlike open-to-the-public "retail"
funds (e.g. mutual funds) which market freely to the public, in most countries, hedge
funds are specifically prohibited from marketing to investors who are not professional
investors or individuals with sufficient private wealth. This limits the information a
hedge fund can legally release. Additionally, divulging a hedge fund's methods could
unreasonably compromise their business interests; this limits the information a hedge
fund would want to release.
Since hedge fund assets can run into many billions of dollars and will usually be
multiplied by leverage, their sway over markets, whether they succeed or fail, is
potentially substantial and there is a continuing debate over whether they should be
more thoroughly regulated.

Fees
Usually the hedge fund manager will receive both a management fee and a
performance fee (also known as an incentive fee). Performance fees are closely
associated with hedge funds, and are intended to incentivize the investment manager
to produce the largest returns possible.
Management fees
As with other investment funds, the management fee is calculated as a percentage of
the net asset value of the fund at the time when the fee becomes payable. Management
fees typically range from 1% to 4% per annum, with 2% being the standard figure.
Therefore, if a fund has $1 billion of assets at the year end and charges a 2%
management fee, the management fee will be $20 million in total. Management fees
are usually calculated annually and paid monthly.
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Performance fees
Performance fees, which give a share of positive returns to the manager, are one of the
defining characteristics of hedge funds. In contrast to retail investment firms,
performance fees are prohibited in the U.S. for stock brokers. A hedge fund's
performance fee is calculated as a percentage of the fund's profits, counting both
unrealized profits and actual realized trading profits. Performance fees exist because
investors are usually willing to pay managers more generously when the investors
have themselves made money. For managers who perform well the performance fee is
extremely lucrative.
Typically, hedge funds charge 20% of gross returns as a performance fee, but again the
range is wide, with highly regarded managers demanding higher fees.
Managers argue that performance fees help to align the interests of manager and
investor better than flat fees that are payable even when performance is poor.
However, performance fees have been criticized by many people, including notable
investor Warren Buffett, for giving managers an incentive to take excessive risk rather
than targeting high long-term returns. In an attempt to control this problem, fees are
usually limited by a high water mark and sometimes by a hurdle rate. Alternatively,
the investment manager might be required to return performance fees when the value
of the fund drops. This provision is sometimes called a claw-back.
High water marks
A "High water mark" is often applied to a performance fee calculation. This means
that the manager does not receive performance fees unless the value of the fund
exceeds the highest net asset value it has previously achieved. For example, if a fund
was launched at a net asset value (NAV) per share of $100, which then rose to $130 in
its first year, a performance fee would be payable on the $30 return for each share. If
the next year it dropped to $120, no fee is payable. If in the third year the NAV per
share rises to $143, a performance fee will be payable only on the extra $13 return
from $130 to $143 rather than on the full return from $120 to $143.
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This measure is intended to link the manager's interests more closely to those of
investors and to reduce the incentive for managers to seek volatile trades. If a high
water mark is not used, a fund that ends alternate years at $100 and $110 would
generate performance fee every other year, enriching the manager but not the
investors. However, this mechanism does not provide complete protection to
investors: a manager who has lost money may simply decide to close the fund and
start again with a clean slate -- provided that he can persuade investors to trust him
with their money. A high water mark is sometimes referred to as a "Loss Carry
forward Provision."
Poorly performing funds frequently close down rather than work without fees, as
would be required by their high water mark policies.
Hurdle rates
Some funds also specify a hurdle rate, which signifies that the fund will not charge a
performance fee until its annualized performance exceeds a benchmark rate, such as
T-bills or a fixed percentage, over some period. This links performance fees to the
ability of the manager to do better than the investor would have done if he had put the
money elsewhere.
Funds which specify a soft hurdle rate charge a performance fee based on the entire
annualized return. Funds which use a hard hurdle rate only charge a performance fee
on returns above the hurdle rate.
Though logically appealing, this practice has diminished as demand for hedge funds
has outstripped supply and hurdles are now rare.
Strategies
Hedge funds are no longer a homogeneous class. Under certain circumstances, an
investor or hedge fund can completely hedge the risks of an investment, leaving pure
profit. For example, at one time it was possible for exchange traders to buy shares of,
say, IBM on one exchange and simultaneously sell them on another exchange, leaving
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pure profit. Competition among investors has leached away such profits, leaving
hedge fund managers with trades that are partially hedged, at best. These trades still
contain residual risks which can be considerable. Some styles of hedge fund investing,
such as global macro investing, may involve no hedging at all. Strictly speaking, it is
not accurate to call such funds hedge funds, but that is current usage.
The bulk of hedge funds describe themselves as long / short equity, but many different
approaches are used taking different exposures, exploiting different market
opportunities, using different techniques and different instruments:
Global macro seeking related assets that have deviated from some anticipated
relationship.
Arbitrage seeking assets that are mispriced relative to related assets.
Convertible arbitrage between a convertible bond and the same company's
equity.
Fixed income arbitrage between related bonds.
Risk arbitrage between securities whose prices appear to imply different
probabilities for one event.
Statistical arbitrage (or StatArb) between securities that have deviated from
some statistically estimated relationship.
Derivative arbitrage between a derivative and its security.
Long / short equity generic term covering all hedged investment in equities.
Short bias emphasizing or solely using short positions.
Equity market neutral maintaining a close balance between long and short
positions.

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Event driven specialized in the analysis of a particular kind of event.
Distressed securities companies that are or may become bankrupt.
Regulation D distressed companies issuing securities.
Merger arbitrage - arbitrage between an acquiring public company and a target
public company.
Other the strategies below are sometimes considered hedge strategies,
although in several cases usage of the term is debatable.
Emerging markets- this usually means unhedged, long positions in small
overseas markets.
Fund of hedge funds - unhedged, long only positions in hedge funds (though
the underlying funds, of course, may be hedged). Additional leverage is
sometimes used.
130-30 funds - Through leveraging, 130% of the money invested in the fund is
used to buy stocks. 30% of the money invested in the fund is used to short
stock.

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CHAPTER VIII: HEDGE FUND RISK

Investing in a hedge fund is considered to be a riskier proposition than investing in a
regulated fund, despite the traditional notion of a "hedge" being a means of reducing
the risk of a bet or investment. The following are some of the primary reasons for the
increased risk:
Leverage - in addition to putting money into the fund by investors, a hedge fund will
typically borrow money, with certain funds borrowing sums many times greater than
the initial investment. Where a hedge fund has borrowed $9 for every $1 invested, a
loss of only 10% of the value of the investments of the hedge fund will wipe out 100%
of the value of the investor's stake in the fund, once the creditors have called in their
loans. At the beginning of 1998, shortly before its collapse, Long Term Capital
Management had borrowed over $26 for each $1 invested.

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Short selling - due to the nature of short selling, the losses that can be incurred on a
losing bet are theoretically limitless, unless the short position directly hedges a
corresponding long position. Therefore, where a hedge fund uses short selling as an
investment strategy rather than as a hedging strategy it can suffer very high losses if
the market turns against it.
Appetite for risk - hedge funds are culturally more likely than other types of funds to
take on underlying investments that carry high degrees of risk, such as high yield
bonds, distressed securities and collateralized debt obligations based on sub-prime
mortgages.
Lack of transparency - hedge funds is secretive entities. It can therefore be difficult
for an investor to assess trading strategies, diversification of the portfolio and other
factors relevant to an investment decision.
Lacks of regulation - hedge funds are not subject to as much oversight from financial
regulators, and therefore some may carry undisclosed structural risks.
Investors in hedge funds are willing to take these risks because of the corresponding
rewards. Leverage amplifies profits as well as losses; short selling opens up new
investment opportunities; riskier investments typically provide higher returns; secrecy
helps to prevent imitation by competitors; and being unregulated reduces costs and
allows the investment manager more freedom to make decisions on a purely
commercial basis.
Legal structure
A hedge fund is a vehicle for holding and investing the funds of its investors. The fund
itself is not a genuine business, having no employees and no assets other than its
investment portfolio and a small amount of cash, and its investors being its clients.
The portfolio is managed by the investment manager, which has employees and
property and which is the actual business. An investment manager is commonly
termed a hedge fund (e.g. a person may be said to work at a hedge fund) but this

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is not technically correct. An investment manager may have a large number of hedge
funds under its management.
Domicile
The specific legal structure of a hedge fund in particular its domicile and the type of
entity used is usually determined by the tax environment of the funds expected
investors. Regulatory considerations will also play a role. Many hedge funds are
established in offshore tax havens so that the fund can avoid paying tax on the
increase in the value of its portfolio. An investor will still pay tax on any profit it
makes when it realizes its investment, and the investment manager, usually based in a
major financial center, will pay tax on the fees that it receives for managing the fund.
At the end of 2004 55% of the worlds hedge funds, accounting for nearly two-thirds
of total hedge fund assets, were established offshore. The most popular offshore
location was the Cayman Islands, followed by the British Virgin Islands, Bermuda and
the Bahamas. The US was the most popular onshore location, accounting for 34% of
funds and 24% of assets. EU countries were the next most popular location with 9% of
funds and 11% of assets. Asia accounted for the majority of the remaining assets.
The legal entity
Limited partnerships are principally used for hedge funds aimed at US-based investors
who pay tax, as the investors will receive relatively favorable tax treatment in the US.
The general partner of the limited partnership is typically the investment manager
(though is sometimes an offshore corporation) and the investors are the limited
partners. Offshore corporate funds are used for non-US investors and US entities that
do not pay tax (such as pension funds), as such investors do not receive the same tax
benefits from investing in a limited partnership. Unit trusts are typically marketed to
Japanese investors. Other than taxation, the type of entity used does not have a
significant bearing on the nature of the fund.
Many hedge funds are structured as master/feeder funds. In such a structure the
investors will invest into a feeder fund which will in turn invest all of its assets into
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the master fund. The assets of the master fund will then be managed by the investment
manager in the usual way. This allows several feeder funds (e.g. an offshore corporate
fund, a US limited partnership and a unit trust) to invest into the same master fund,
allowing an investment manager the benefit of managing the assets of a single entity
while giving all investors the best possible tax treatment.
The investment manager, which will have organized the establishment of the hedge
fund, may retain an interest in the hedge fund, either as the general partner of a limited
partnership or as the holder of founder shares in a corporate fund. Founder shares
typically have no economic rights, and voting rights over only a limited range of
issues, such as selection of the investment manager most of the funds decisions are
taken by the board of directors of the fund, which is self-appointing and independent
but invariably loyal to the investment manager.

Open-ended nature
Hedge funds are typically open-ended, in that the fund will periodically issue
additional partnership interests or shares directly to new investors, the price of each
being the net asset value (NAV) per interest/share. To realize the investment, the
investor will redeem the interests or shares at the NAV per interest/share prevailing at
that time. Therefore, if the value of the underlying investments has increased (and the
NAV per interest/share has therefore also increased) then the investor will receive a
larger sum on redemption than it paid on investment. Investors do not typically trade
shares between themselves and hedge funds do not typically distribute profits to
investors before redemption. This contrasts with a closed-ended fund, which has a
limited number of shares which are traded between investors, and which distributes its
profits.
Listed funds

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Corporate hedge funds often list their shares on smaller stock exchanges, such as the
Irish Stock Exchange, in the hope that the low level of quasi-regulatory oversight will
give comfort to investors and to attract certain funds, such as some pension funds, that
have bars or caps on investing in unlisted shares. Shares in the listed hedge fund are
not traded on the exchange, but the funds monthly net asset value and certain other
events must be publicly announced there.
A fund listing is distinct from the listing or initial public offering (IPO) of shares in
an investment manager. Although widely reported as a "hedge-fund IPO", the IPO of
Fortress Investment Group LLC was for the sale of the investment manager, not of the
hedge funds that it managed.
Hedge fund management worldwide
In contrast to the funds themselves, hedge fund managers are primarily located
onshore in order to draw on larger pools of financial talent. The US East coast
principally New York City and the Gold Coast area of Connecticut (particularly
Stamford and Greenwich) is the world's leading location for hedge fund managers
with approximately double the hedge fund managers of the next largest center,
London. With the bulk of hedge fund investment coming from the US, this
distribution is natural.
London is Europes leading center for the management of hedge funds. At the end of
2006, three-quarters of European hedge fund investments, totaling $400bn (200bn),
were managed from London, having grown from $61bn in 2002. Australia was the
most important center for the management of Asia-Pacific hedge funds, with managers
located there accounting for approximately a quarter of the $140bn of hedge fund
assets managed in the Asia-Pacific region in 2006.
Regulatory Issues
Part of what gives hedge funds their competitive edge, and their cachet in the public
imagination, is that they straddle multiple definitions and categories; some aspects of
their dealings are well-regulated, others are unregulated or at best quasi-regulated.
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Offshore regulation
Many offshore centers are keen to encourage the establishment of hedge funds. To do
this they offer some combination of professional services, a favorable tax
environment, and business-friendly regulation. Major centers include Cayman Islands,
Dublin, Luxembourg, British Virgin Islands and Bermuda. The Cayman Islands have
been estimated to be home to about 75% of worlds hedge funds, with nearly half the
industry's estimated $1.225 trillion AUM[11].
Hedge funds have to file accounts and conduct their business in compliance with the
requirements of these offshore centers. Typical rules concern restrictions on the
availability of funds to retail investors (Dublin), protection of client confidentiality
(Luxembourg) and the requirement for the fund to be independent of the fund
manager.
Many offshore hedge funds, such as the Soros funds, are structured as mutual funds
rather than as limited partnerships.
Hedge Fund Indices
There are a number of indices that track the hedge fund industry. These indices come
in two types, Investable and Non-investable, both with substantial problems. There are
also new types of tracking product launched by Goldman Sachs and Merrill Lynch,
"clone indices" that aim to replicate the returns of hedge fund indices without actually
holding hedge funds at all.
Investable indices are created from funds that can be bought and sold, and only Hedge
Funds that agree to accept investments on terms acceptable to the constructor of the
index are included. Investability is an attractive property for an index because it makes
the index more relevant to the choices available to investors in practice, and is taken
for granted in traditional equity indices such as the S&P500 or FTSE100. However,
such indices do not represent the total universe of hedge funds and may underrepresent the more successful managers, who may not find the index terms attractive.

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Fund indexes include Barclay Hedge, Hedge Fund Research, Eureka hedge Indices,
Credit Suisse Tremont and FTSE Hedge.
The index provider selects funds and develops structured products or derivative
instruments that deliver the performance of the index, making investable indices
similar in some ways to fund of hedge funds portfolios.
Non-investable benchmarks are indicative in nature, and aim to represent the
performance of the universe of hedge funds using some measure such as mean,
median or weighted mean from a hedge fund database. There are diverse selection
criteria and methods of construction, and no single database captures all funds. This
leads to significant differences in reported performance between different databases.
Non-investable indices inherit the databases' shortcomings, or strengths, in terms of
scope and quality of data. Funds participation in a database is voluntary, leading to
self-reporting bias because those funds that choose to report may not be typical of
funds as a whole. For example, some do not report because of poor results or because
they have already reached their target size and do not wish to raise further money. This
tends to lead to a clustering of returns around the mean rather than representing the
full diversity existing in the hedge fund universe. Examples of non-investable indices
include an equal weighted benchmark series known as the HFN Averages, and
revolutionary rules based set known as the Lehman Brothers/HFN Global Index Series
which leverages an Enhanced Strategy Classification System.
The short lifetimes of many hedge funds means that there are many new entrants and
many departures each year, which raises the problem of survivorship bias. If we
examine only funds that have survived to the present, we will overestimate past
returns because many of the worst-performing funds have not survived, and the
observed association between fund youth and fund performance suggests that this bias
may be substantial. As the HFR and CISDM databases began in 1994, it is likely that
they will be more accurate over the period 1994/2000 than the Credit Suisse database,
which only began in 2000.

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When a fund is added to a database for the first time, all or part of its historical data is
recorded ex-post in the database. It is likely that funds only publish their results when
they are favorable, so that the average performances displayed by the funds during
their incubation period are inflated. This is known as "instant history bias or backfill
bias.
In traditional equity investment, indices play a central and unambiguous role. They are
widely accepted as representative, and products such as futures and ETFs provide
liquid access to them in most developed markets. However, among hedge funds no
index combines these characteristics. Investable indices achieve liquidity at the
expense of representativeness. Non-investable indices are representative, but their
quoted returns may not be available in practice. Neither is wholly satisfactory.
Debates and controversies
Privacy issues
As private, lightly regulated partnerships, hedge funds do not have to disclose their
activities to third parties. This is in contrast to a fully regulated mutual fund (or unit
trust) which will typically have to meet regulatory requirements for disclosure. An
investor in a hedge fund usually has direct access to the investment advisor of the
fund, and may enjoy more personalized reporting than investors in retail investment
funds. This may include detailed discussions of risks assumed and significant
positions. However, this high level of disclosure is not available to non-investors,
contributing to hedge funds' reputation for secrecy. Several hedge funds are
completely "black box", meaning that their returns are uncertain to the investor.
Restrictions on marketing and the lack of regulation is that there are no official hedge
fund statistics. An industry consulting group, HFR (hfr.com), reported at the end of the
second quarter 2003 that there are 5,660 hedge funds worldwide managing $665
billion. For comparison, at the same time the US mutual fund sector held assets of
$7.818 trillion (according to the Investment Company Institute).
Market capacity
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Analysis of the rather disappointing hedge fund performance in 2004 and 2005 called
into question the alternative investment industry's value proposition. Alpha may have
been becoming rarer for two related reasons. First, the increase in traded volume may
have been reducing the market anomalies that are a source of hedge fund performance.
Second, the remuneration model is attracting more and more managers, which may
dilute the talent available in the industry.
However, the market capacity effect has been questioned by the EDHEC Risk and
Asset Management Research Centre through a decomposition of hedge fund returns
between pure alpha, dynamic betas, and static betas.
While pure alpha is generated by exploiting market opportunities, the dynamic betas
depend on the managers skill in adapting the exposures to different factors, and these
authors claim that these two sources of return do not exhibit any erosion. This
suggests that the market environment (static betas) explains a large part of the poor
performance of hedge funds in 2004 and 2005.

Systematic risk
Hedge funds came under heightened scrutiny as a result of the failure of Long-Term
Capital Management (LTCM) in 1998, which necessitated a bailout coordinated by the
U.S. Federal Reserve. Critics have charged that hedge funds pose systemic risks
highlighted by the LTCM disaster. The excessive leverage (through derivatives) that
can be used by hedge funds to achieve their return is outlined as one of the main
factors of the hedge funds contribution to systematic risk.
The ECB (European Central Bank) has issued a warning on hedge fund risk for
financial stability and systemic risk: "... the increasingly similar positioning of
individual hedge funds within broad hedge fund investment strategies is another major
risk for financial stability which warrants close monitoring despite the essential lack
of any possible remedies. This risk is further magnified by evidence that broad hedge

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fund investment strategies have also become increasingly correlated, thereby further
increasing the potential adverse effects of disorderly exits from crowded trades."
The Times wrote about this review: "In one of the starkest warnings yet from an
official institution over the role of the burgeoning but secretive industry, the ECB
sounded a note of alarm over the possible repercussions from any collapse of a hedge
fund, or group of funds."
However, the ECB statement itself has been criticized by a part of the financial
research community. These arguments are developed by the EDHEC Risk and Asset
Management Research Centre: The main conclusions of the study are that the ECB
articles conclusion of a risk of disorderly exits from crowded trades is based on
mere speculation. While the question of systemic risk is of importance, we do not
dispose of enough data to reliably address this question at this stage; it would be
worthwhile for financial regulators to work towards obtaining data on hedge fund
leverage and counterparty credit risk. Such data would allow a reliable assessment of
the question of systemic risk, and besides evaluating potential systemic risk, it
should be recognized that hedge funds play an important role as providers of
liquidity and diversification.
The potential for systemic risk was highlighted by the near-collapse of two Bear
Stearns hedge funds in June 2007. The funds invested in mortgage-backed securities.
The funds' financial problems necessitated an infusion of cash into one of the funds
from Bear Stearns but no outside assistance. It was the largest fund bailout since Long
Term Capital Management's collapse in 1998. The U.S. Securities and Exchange
Commission is investigating.
Performance measurement
The issue of performance measurement in the hedge fund industry has led to literature
that is both abundant and controversial. Traditional indicators (Sharpe, Treynor,
Jensen) work best when returns follow a symmetrical distribution. In that case, risk is
represented by the standard deviation. Unfortunately, hedge fund returns are not
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normally distributed, and hedge fund return series are auto correlated. Consequently,
traditional performance measures suffer from theoretical problems when they are
applied to hedge funds, making them even less reliable than is suggested by the
shortness of the available return series.
Innovative performance measures have been introduced in an attempt to deal with this
problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003), Omega by Keating
and Shadwick (2002), Alternative Investments Risk Adjusted Performance (AIRAP)
by Sharma (2004), and Kappa by Kaplan and Knowles (2004). An overview of these
performance measures is available in Ghin, W., 2006, The Challenge of Hedge Fund
Performance Measurement: a Toolbox rather than a Pandoras Box, EDHEC Risk and
Asset Management Research Center, Position Paper, December. However, there is no
consensus on the most appropriate absolute performance measure, and traditional
performance measures are still widely used in the industry.
Relationships with analysts
In June 2006, the U.S. Senate Judiciary Committee began an investigation into the
links between hedge funds and independent analysts, and other issues related to the
funds. Connecticut Attorney General Richard Blumenthal testified that an appeals
court ruling striking down oversight of the funds by federal regulators left investors
"in a regulatory void, without any disclosure or accountability." The hearings heard
testimony from, among others, Gary Aguirre, a staff attorney who was recently fired
by the SEC.
Transparency
Some hedge funds, mainly American, do not use third parties either as the custodian of
their assets or as their administrator (who will calculate the NAV of the fund). This
can lead to conflicts of interest, and in extreme cases can assist fraud. In a recent
example, Kirk Wright of International Management Associates has been accused of
mail fraud and other securities violations which allegedly defrauded clients of close to
$180 million.
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CHAPTER IX: THE SCENARIO IN INDIA

More than a dozen hedge funds have received the regulatory nod after the Securities
and Exchange Board of India (SEBI) allowed hedge fund-like strategies to launch
operations in India under alternative investment fund (AIF) Category-III segment.
The funds that got the regulatory green signal include Avendus India, Karvy Capital,
Motilal Oswal, Capveda, DSP BlackRock, Edelweiss and Ambit Capital. The other
hedge funds that received SEBIs approval are Forefront, Unifi AIF, Malabar Capital,
Monsoon Alternative Investment, Redart India and Mavenvest Absolute Return Fund.
One hedge fund, SBI Pipe Fund, is awaiting approval.
A popular product overseas, hedge funds in India are in their infancy. They are similar
to mutual funds in the way they pool in investors money and invest it in stocks and
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stocks derivatives and bonds, and returns are distributed among unitholders. Unlike
MFs, hedge funds use far more complex strategies, such as long-short, derivatives and
leverage, among others.
Hedge funds have gained popularity abroad with increasing volatility in global
markets, as they are viewed as risky but money-spinning products.
Till now, Indian investors had to invest money in long-only funds such as portfolio
management services (PMS) and they had no way to bet against the market.
Sebis new rules for alternative investment funds Category III segment allows hedge
fund-like strategies such as short selling. Short sales or selling a stock that one does
not own are prohibited in PMS schemes.
Till the new local hedge funds are allowed, only foreign investors could participate in
hedge funds through Mauritius or other offshore-based funds.
In addition to short selling, hedge funds can leverage twice their assets, meaning an
India hedge fund of Rs 100 crore assets can take bets worth up to Rs 200 crore,
according to Sebi.
The total asset size of local hedge funds in India is not known. The minimum ticket
size for investors putting money in these hedge funds is Rs 1 crore. This is to ensure
small investors are kept away from betting on these risky strategies.
The total funds managed by hedge funds in India may be in the region of Rs 300-500
crore, said a fund manager, adding that Karvy, Ambit, Forefront and Capveda are up
and running while others are just starting off.
Most fund houses may be managing just Rs 30-40 crore or even lower. Most of this
too are proprietary money, said an industry official. The law stipulates AIF Category
III to have minimum of Rs 20 crore of assets under management (AUM).
Some funds are up and running while most others are in fund raising mode right
now, said another industry official.
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Regulatory Issue for Hedge Funds in India
With the notification of SEBI (Mutual Fund) Regulations 1993, the asset management
business under private sector took its root in India. In the same year SEBI, also
notified Regulations and Rules governing Portfolio Managers who pursuant to a
contract or arrangement with clients, advise clients or undertake the management of
portfolio of securities or funds of the client. We have however, no information about
any hedge funds domiciled in India. Further, on account of limited convertibility,
offshore hedge funds have yet to offer their products to Indian investors within India.
Recently, RBI through liberalized remittance scheme, allowed resident individuals to
remit upto US $ 25,000 per year for any current or capital account transaction. The
liberalized scheme will allow Indian individual investors to explore the possibility of
investing in offshore financial products. Considering the existing limit being only US
$ 25,000 per year, Indian market may not be attractive to hedge fund product
marketing. As long as there will be restriction on capital account convertibility,
foreign hedge funds, by virtue of their minimum investment limit being $ 100,000 or
higher, do not seem to be excited to access investment from Indian investors in India.
It may be clearly understood that the suggestions put forth in the following paragraphs
are in no way aimed at allowing foreign hedge funds to mobilise investment from
India by offering their products to Indian investors. Therefore regulatory issues related
to investor protection have not been considered for this Report.
Some hedge funds have invested in offshore derivative instruments (PNs) issued by
FIIs against underlying Indian securities. Through this route hedge funs can derive
economic benefit of investing in Indian securities without directly entering the Indian
market as FIIs or their sub-accounts. Through recent amendments to the FII
Regulations (Regulation 15A and 20 A), the regulatory regime has been further
strengthened and periodic disclosures regime has been introduced. As at the end of
March, 2004, total investment by hedge funds. In the offshore derivative instruments
(PNs) against Indian equity, are Rs. 8050 crores which represents about 8% total net
equity investments of all FIIs. On the basis of market value, the hedge funds account
for about 5% of the market value of the total assets held by the FIIs in India.
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The current fiscal year (2003-2004) has seen a spectacular increase in FII activities in
Indian market. Till this report is filed FIIs have already invested US $ 10 bn. during
this year alone which is a record. Robust economic fundamentals, strong corporate
earnings and improvement in market micro structure are driving the FII interest in
India. Investors all over the world are keen to come to Indian market. From informal
discussions with institutional investors including some reputed and well established
hedge funds, one could gauge the extent of interest they have about Indian markets.
During the discussions they have requested whether India, like other Asian emerging
markets, can provide a regulatory framework that will allow them to directly invest in
Indian market in a transparent manner. In this context , the following approach may be
considered for allowing the well-established hedge funds to invest in Indian markets
as a registered entity under the SEBI (Foreign Institutional Investors) Regulations,
1995.
Relevant Provisions of FII Regulations:
Though hedge funds are not an excluded category of foreign institutional investors
under the SEBI (FII) Regulations, 1995 they are , however, by virtue of not being
regulated by securities regulators in their place of incorporation or operations , cannot
come as FII under the present provisions of SEBI (FII) Regulations. Regulation 6 (i)
(b) of the FII Regulations requires an FII applicant to be a regulated entity in its place
of incorporation or operations.
The FII Regulations allow sub-accounts sponsored by registered FIIs to invest in
India. Regulation 2 (k) defines sub-account which includes foreign corporates or
foreign individuals and those institutions, established or incorporated outside India
and those funds, or portfolios, established outside India, whether incorporated or not,
on whose behalf investments are proposed to be made in India by a foreign
institutional investor. Further, provisions of the regulation 13 lay down the conditions
and procedure for granting registration to a sub-account of an FII. Hedge Funds of
almost all variations can meet the requirements of sub-accounts if they are fit and
proper persons. However, based on (an internal administrative decision) if an
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applicant indicates in the application that it is a hedge fund, the consideration of the
application is withheld. Since granting of registration to FII/sub-accounts is based on
the disclosure of details and on the undertaking given by the applicant in the
application form, it could be possible that a few entities who described their activities
in the application form in terms other than hedge funds could have already got
registration as sub- accounts. However, it must be remembered that all sub-accounts
have to be sponsored by registered FIIs who are required to be regulated entities by
the relevant regulators in their home countries.
Identifying Hedge Funds
As mentioned in earlier paragraphs, hedge funds do not have, any universally accepted
definition. Therefore, identifying a hedge fund is the first challenge that a regulator
faces. An approach for identifying hedge funds, as suggested by IOSCO is to look at
the kinds of characteristics of fund management strategies employed by institutions.
Hedge funds would at least exhibit some of the following characteristics:
Borrowing and leverage restrictions, which are typically included in Mutual
Fund Regulation are not applied, and many (but not all) hedge funds use high
levels of leverage.
Significant performance fees (often in the form or percentage of profits) are
paid to the manager in addition to an annual management fees.
Investors are typically permitted to redeem their interests periodically, e.g.
quarterly, semi-annually or annually;
Often significant own funds are invested by manager;
Derivatives are used, often for speculative purposes, and there is an ability to
short sell securities;
More diverse risks or complex underlying products are involved.

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The distinguishing characteristics of hedge funds are not limited to this and the list
may need to adapt depending on the changing market dynamics. Further, it might be
appropriate to also consider the investment strategy followed by particular funds, such
as long/short exposures, leverage and / or hedging and arbitrage techniques. On the
basis of these characteristics, it will be possible to identify an applicant as a hedge
fund.
Investment limits applicable to FIIs:
Chapter II of the SEBI (Foreign Institutional Investors) Regulations, 1995 interalia list
out the instruments in which an FII/sub-account can invest. The regulation does not
include currency or commodities as eligible instruments for investment for the FIIs .
Therefore, currency trading or investment in commodity related financial products
will not be an option for any hedge funds under the present FII Regulations.
The SEBI (Foreign Institutional Investors) Regulations, 1995 also lays down scripwise and fund wise maximum limits a fund can invest. Further, through circular No.
SMD/DC/CIR-11/02 dated February 12, 2002 and SEBI/DNAD/CIR -21/2004/03/09
dated March 9, 2004 issued by Secondary Market Department, position limits for
investment by FIIs in derivatives have been advised. These limits will help diversify
the foreign hedge fund investments and will help in jettisoning concentration in any
specific scrip. The provisions of Chapter III (Regulation 15 (3) (a)) disallows short
selling by FIIs and stipulates that all trades by FIIs are delivery based. The provision
will clearly keep the hedge funds if allowed to invest as FIIs out of short selling at
least in the cash segment. It is therefore, clear that existing provisions in the FII
Regulations include several checks and balances which can keep our market safe from
potential market abuse and manipulation.
Additional Regulatory Concerns:
In view of the increasing popularity among the institutions as well as their increasing
interest in the Indian market, it might be time to provide a limited window to this
growing segment of asset management industry within the existing framework of the
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SEBI (Foreign Institutional Investors) Regulations. While opening up our market one
cannot be oblivious to the special concerns associated with the creative fund
management strategies used by these funds. Thus, the approach adopted in
formulating the following policy suggestions has been that of transparent and
regulated access with abundant caution. Para 4.4 of this section has already outlined
the existing provisions in the SEBI (Foreign Institutional Investors) Regulations, 1995
and the Guidelines issued by SEBI which an address the concerns related to currency
speculations, short selling, scrip wise concentration in the cash market and excessive
positions in the derivative segment of our market. As mentioned earlier, these types of
funds raise special regulatory concerns which are necessary to be addressed with
special regulatory provisions. In this context, following additional provisions have
been suggested with respect to hedge funds seeking registration as FII :
The investment adviser to the hedge funds should be a regulated investment
advisor under the relevant Investor Advisor Act or the fund is registered under
Collective Investment Fund Regulations or Investment Companies Act .
At least 20% of the corpus of the fund should be contributed by the investors
such as pension funds, university funds, charitable trusts or societies,
endowments, banks and insurance companies. The presence of institutional
investors in the fund is expected to ensure better governance on the part of the
fund manager and fund administrators. Further, institutional investors may help
fund managers to take a long term perspective of the market.
The fund should be a broad based fund in terms of the SEBI (Foreign
Institutional Investors) Regulations, particularly in terms of the explanation to
Regulation 6 (1) (d).
The fund manager or investment adviser must have experience of at least 3
years of managing funds with similar investment strategy that the applicant
fund has adopted. This provision is expected to allow well managed funds to

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access our market and at the same time, keep our markets insulated from the
possible adverse effects of trial and errors by uninitiated rookies.
Hedge funds as a whole are becoming an important segment of the asset management
industry and gaining popularity from investors particularly from the high net worth
investors, universities, charitable funds, endowments, pension funds, insurance and
other institutional investors. The asset under management of the hedge funds are
growing on a double digit rate. All hedge funds are not necessarily speculative funds
though most of them provide an alternative investment options for the investors
through innovative investment strategy.
The issues discussed and suggestions placed above are intended to widen the FII
window to allow these alternatives invest pools to our securities markets in a
transparent and orderly manner. In addition, the suggestions also provide for adequate
safety measures to address legitimate concerns associated with these funds. The
alternative investment pools if allowed to investment in Indian markets will be a
source of additional liquidity and will also diversify the pool of foreign investments in
Indian market.

CHAPTER XI: CASE STUDIES

Karvy Capital
Case Study: Business Owner
Mr. Murthy (52 years old) is the MD of a legal outsourcing company Marathon
Solutions, based out of Bangalore. The company has a total of 70 employees across
functions and an annual revenue run-rate of ~Rs. 60crs. The clients are primarily
based out of the US. Mr. Murthy owns 55% in the company - 35% is controlled by
his brother who is the Chief Operating Officer and the remaining 10% is owned by
employees of the company.
Family of Mr. Murthy

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Mrs. Ritu -his wife is an interior designer. She is 48 years old. They have one daughter
Neha (26 years old) and one son Rahul (19 years old). Neha is married and settled in
Kolkata. Rahul is currently studying in SY B.Com he intends to pursue an
international MBA in 4 years time.
Personal Portfolio
Equity - 18crs: The direct equity portfolio had a total of 73 stocks with a current
market value of 12crs. The stocks have been added to his portfolio over a period of
time and are diversified across sectors and market capitalization. The total mutual
fund investment corpus is Rs. 4.5crs which has been invested in a total of 13 schemes
primarily in NFOs and closed ended schemes. The current value of the same is Rs
3.8crs. Rs 2 crs was invested in a mid-cap Portfolio Management Service (PMS)
managed by a local brokerage house. The money was invested in 2 tranches of 1cr
each in 2005 and 07. The current value of the same is Rs. 2.1crs.
Debt - 1.2crs: There is a total of 45L lying in various bank fixed deposits across
tenures. The average maturity of the same is ~3 years. Besides this, the total PPF
contribution across the family holders is 70L. The family also owns 8L in NSCs.
Real Estate 7crs: The primary residence in Bangalore is worth Rs. 4crs in market
value. There is a loan outstanding of Rs. 1cr against it with an EMI of Rs. 150,000 per
month. Besides, Mr. Murthy owns a flat in Mumbai valued at Rs.3crs and a plot of
land near Delhi worth 1cr.
Private Equity: Mr. Murthy has a commitment of Rs. 1cr to a private equity fund.
Out of this a total of Rs.25L has been drawn down and a further 25L drawdown is
expected this year. Cash: The current savings bank account balance is Rs. 35L
Recommendations
Personal Portfolio

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1. KARVY Private Wealth helped to outline the key financial goals of the family
which included building a retirement corpus for Mr. Murthy, a education fund
for Rahul and a gift of Rs. 50L to Neha when she turns 30.
2. The current portfolio was heavily skewed toward equity (70%) and real estate
(25%). KPW recommended increasing the debt component of the portfolio in
line with building up an retirement corpus for Mr. Murthy. The target asset
allocation at the end of the financial year was as follows:Equity: 45%
Debt: 30%
Real Estate: 25%
Gold : 5%
3. KPW analyzed the Mutual Fund (MF) portfolio and recommended divesting 6
out of the 13 mutual fund schemes which had been underperforming the
markets. The surplus cash from this was used to build up the debt component of
the portfolio through purchase of NABARD and PFC bonds. Part of the money
was invested in 3 year bank fixed deposits as well.
4. The number of stocks in the current direct equity portfolio was too high
resulting in poor decision making on the portfolio and underperformance to the
market. The top 6 stocks made up over 55% of the portfolio. We divided the
portfolio into a Core and a Satellite portfolio. The core included 12 large
cap stocks and comprised 70% of the total portfolio. The other 30% was
designated as the Satellite portfolio and comprised of 8 stocks. The stocks in
this segment were mostly midcap and small cap in nature. No more than 5% of
the portfolio was invested in one stock and the exposure of any sector was
maintained below 20%. The remaining stocks were sold.
5. The PMS fund had been underperforming the mid-cap index by over 8% since
inception. KPW recommended exiting the same once the lock in for the same
was completed. The proceeds were to be recommended in debt instruments.
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6. The current housing loan was with a leading private bank at a floating rate of
12%. KPW analyzed the current loan rates in the market and recommended
switching the loan to a PSU bank which provided the loan at a floating rate of
10.5%. 20L of the surplus cash was used to prepay part of the housing loan as
well.
7. The financial goals with respect to the children were well managed for. The
commitment to the private-equity fund would be made from internal accruals
through the year.
Corporate Portfolio
1. FX Hedging
Almost all the revenues (~90%) of the company were USD denominated
whereas the costs were mostly INR in nature (~60%). The company policy was
to remit USD back to India on an ad-hoc manner using spot rates in the
currency market. As a result the reported revenues of the company had been
extremely volatile.
KARVY Private Wealth designed a FX hedging strategy for the company based
on the payments expected from the clients and the costs to be incurred in the
foreign country. This ensured the currency risk was managed better for a
majority of the remittances to be made for the current financial year.
The execution of the entire strategy was carried out by KPW using a
combination of currency futures available on the exchanges for shorter dated
exposure (<3 months) and forward contracts with a PSU bank for contracts
with a longer dated tenure.
2. Managing

Liquid

Cash

Effectively

The surplus cash lying with the company (on an average~ 40L) was being
invested in a single liquid fund floated by the Royal Fund Manager. On

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analysis by KPW, we found the following issues with the current investment in
the liquid fund:

Lack of diversification

Mismatch in tenure of requirements of funds and investment horizon

Additional risk given the high exposure to real estate and NBFCs
KPW recommended the following steps to address the issue:-

Broaden the range of investments chosen

Increase number of liquid funds to diversify risk. These funds were

chosen on the basis of the current portfolio, past returns, track record of
the fund manager and the stability of the fund house in managing debt
schemes.

Minimize credit risk across the investments

Percentage Allocation

Time Horizon

Liquid Funds

40%

<3 months

FMP/FDs 12 months

25%

12 months

Structured Products with Capital Protection

10%

18-24 months

Corporate Bonds

25%

3 years

Case Study: Corporate Professional

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Vishal: Senior Executive earning Rs. 40 lakh a year
Amrita: Marketing consultant earning ~Rs. 25 lakh a year not fulltime in nature
Daughter Nidhi: 8 years old
Existing assets
Own house: Rs. 80 lakh in market value; loan outstanding of Rs. 40 lakh against it
with an EMI of Rs. 55,000 per month entirely in Vishals name owing to the salaried
job.
Plot of land purchased from Amritas savings in joint name: Cost value Rs. 7 lakh,
worth Rs. 11 lakh now
Public Provident Fund (PPF): Rs. 8 lakh in Vishals name, Rs. 9 lakh in Amritas
name and Rs. 3 lakh in Nidhis name
Employee Provident Fund (EPF): Rs. 7 lakh in Vishals name
Fixed Deposits (FDs): Rs. 15 lakh held jointly earning 8%
Insurance
1. Rs. 20 lakh for Vishal through a combination of policies and another Rs. 60
lakh from his employer
2. Rs. 35 lakh for Amrita.
3. Surrender value of insurance policies: Rs. 12 lakh across Vishal and Amrita.
Payout of Rs. 40 lakh expected in 10 years time; annual insurance linked
investments are Rs. 1 lakh.
Health cover as provided by Vishals employer Rs. 3 lakh floating cover for the
family
Equity holdings
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1. Mutual funds: Rs. 4 lakh, not actively managed total of 13 schemes including
some NFOs and closed ended schemes
2. Equity stocks: Amritas demat has stocks worth Rs. 3 lakh which she manages
semiactively (12 stocks)
Other investments: A real estate fund they bought in joint name two years back at
cost value of Rs. 10 lakh
Current bank balance is Rs. 7 lakh not invested anywhere owing to lack of suitable
opportunities.
Milestones
Related to Nidhi education in 10 years from now at Rs. 20 lakh in todays rupees;
higher education in 14 years from now at Rs. 40 lakh in todays rupees; marriage in 17
years from now at Rs. 30 lakh in todays rupees and finally a gift of Rs. 50 lakh (if
possible) in 18 years from now
Amrita is thinking of bolstering her consulting practice by hiring a couple of
associates and taking up a fulltime office. This would entail a spend of Rs. 8 lakh over
the period of a year
Vishal and Amrita are thinking of buying a new car for Rs. 11 lakh. They are
thinking about taking a loan for the same.
Vishal has been using his bonus to retire the home loan which had become quite
costly in last year. He plans to do the same this year as well. The estimated bonus
amount is Rs. 8 lakh.
Portfolio view and shuffle - Investment portfolio
Total real estate: Rs. 21 lakh
Equity: Rs. 11 lakh (including Rs. 4 lakh from insurance surrender value)
Debt: Rs. 50 lakh (including Rs. 8 lakh from insurance surrender value)
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Cash: Rs. 7 lakh
Total: Rs. 89 lakh
Following observations/recommendations emerge
The portfolio is quite skewed towards debt owing to the investments in PPF, EPF,
insurance policies and FDs. Of these only the FDs are semi-liquid and the insurance
policies can be altered with some costs. The others are unalterable.
Hence we suggest that the Fixed Deposits be invested in other assets such as equity
and alternate investments.
The cash balance is sufficient but should be redirected into liquid funds to maximize
the returns from cash holdings without sacrificing liquidity
The real estate allocation is sufficient. It need not be altered. The alternative assets
can be chosen from Private Equity (PE) funds, commodities or international
investments.
Within the equity allocation, mutual funds portfolio should be evaluated and
restructured as needed. The equity stock portfolio can remain as it is currently
though it can be managed more actively
Some of the incremental equity allocation can be done through structured products
which will ensure protection from near term downside
Risk management observations
Vishals total cover is barely adequate. Also it is subject to his continued
employment with the present employer (or the new employer providing similar cover).
Vishal should take Rs. 50 lakh of term insurance
Amritas life cover is sufficient.

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The family should take additional medical insurance to build the policy history
irrespective of the employer. The family should also add critical illness cover since it
is missing in the current set-up
The family should insure their home and belongings.
Amrita can think about professional indemnity cover depending on her client profile
Milestones
Vishal and Amrita need to start keeping aside Rs. 25,000 for their daughters
education and marriage. They should use two different policies for education and
marriage and invest the same in child plans with moderate risk profile
For the Nidhi gift fund, they can invest Rs. 10,000/- in equity linked child plan with
aggressive risk profile.
Amritas business venture can be comfortably financed by the savings currently with
the family. However a careful business planning and cashflow based evaluation is
called for to justify the investment in light of its payoffs
The car can be purchased as well. However, it would not make sense to retire a low
cost loan (home loan) and take on a high cost loan (car loan). Hence the bonus should
be used for the down payment of the car rather than home loan retirement. While
thinking about prepayment in future, the car loan should take precedence since it is
higher cost and one without tax benefits.
In general the risk taking ability of the family is moderate to high. They need not
retire their home loan that aggressively. Instead they can use the funds to build long
term assets with at least 10% rate of return in neutral markets.
Case Study: Self Employed Professional
Name: Dr. Asmita Shinde (42 years)
Spouse: Prof. Gururaj Gokhale (45 years)
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Son: Vidhan (18 years)
Existing assets
Equity mutual funds: Rs. 3 lakh
Equity stocks: Rs. 32 lakh (Rs. 29 lakh of this in three stocks Reliance Industries
Ltd, HDFC Ltd and L&T)
Public Provident Fund (PPF): Rs. 8 lakh
Fixed Deposits: Rs. 13 lakh
Insurance policies surrender value (cover)
1. Endowment: Dr. Asmita - Rs. 12 lakh (Rs. 22 lakh)
2. ULIP: Dr Asmita - Rs. 6 lakh (Rs. 20 lakh)
3. Term: Prof. Gokhale - Nil (Rs. 50 lakh)
Clinic run by Dr. Asmita: Rs. 20 lakh for property and Rs. 12 lakh for equipment at
cost
Own home worth Rs. 1.2 Cr with no loan against it.
Milestones
Dr. Asmita is keen to join hands with few other doctors and offer a holistic
diagnostic clinic to patients. She has thought about a plan which requires her to leave
her current clinic and relocate her practice to a larger center. She may also have to
contribute in terms of initial set up cost to the tune of Rs. 8 lakh
Both Dr Asmita and Prof Gokhale have been thinking about creating an education
trust for sponsoring education of bright students in need. They have necessary
approvals to create such a trust. They are thinking of allocating Rs. 5 lakh to this trust
to start with and then add Rs. 2 lakh every year to the trusts corpus. They are thinking
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that the money for the trust can be managed such that 8-10% returns can be generated
for the scholarships every year.
Dr Asmita and Prof Gokhale are looking to plan for their retirement. They are
thinking of keeping building a total corpus of Rs. 1.5 Cr in next 10 years (including
current assets) after paying for their sons higher education budgeted at Rs. 30 lakh
in 3 years. They

are expecting this to be sufficient for generating Rs. 1 lakh of

income per month post retirement (in the retirement years rupees)
Portfolio view: observations and recommendations
The equity portfolio is highly concentrated. The downside risk of such a portfolio is
quite high. Also the decision to stick to the portfolio is likely to be driven by inertia
rather than specific analysis. It is recommended that the family should build a more
diversified portfolio of at least 10 stocks if they are planning to monitor is actively and
4-5 mutual funds if their management is unlikely to be very active.
The overall portfolio allocation is as follows
1. Debt: Rs. 43 lakh
2. Equity: Rs. 41 lakh
3. Real estate: Rs. 20 lakh
This allocation is in line with the familys risk taking ability. They can consider
diversifying away from debt and equity into alternate assets such as managed futures,
gold and private equity. The allocation of such assets can be Rs. 20 in total drawing
Rs. 10 lakh each from current debt and equity allocation.
They can also consider holding some of their equity holdings in the form of
structured products up to Rs. 15 lakh. This will ensure protection against drastic fall
in equity markets in next 2-3 years.

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The fixed deposits can be moved into more tax efficient instruments such as fixed
maturity plans and long tenor bonds such as those issued by NABARD and PSU
banks.
Risk management
Dr Asmita should think through the general insurance cover required for her clinic if
she decides to continue using it. Else, she should urge her colleagues in the new center
to take comprehensive cover for the property and equipment in the clinic
Dr Asmita should consider taking professional indemnity cover to protect from
financial losses arising out of her work (e.g. liabilities from a patient suing her)
The life insurance cover that both Dr Asmita and Prof Gokhale have is sufficient;
especially considering their present stock of liquid assets.
The entire family should be covered with general medical insurance and critical
illness insurance.
Dr Asmita should consider the risk to her income arising out of the shift into the new
center. She can postpone renting out the present clinic premises for a period of 3
months to make sure she is prepared for reversing her decision if need be.
Milestones
The family has sufficient funds for meeting all the milestones. They should however
carefully create asset pools for each milestone. The planned educational trust would
already account for one such pool. Besides, they should create a separate asset pool
for their retirement corpus and for their sons higher education.
The retirement corpus planned should incorporate the impact of inflation in post
retirement years on the corpus requirement. For a monthly income of Rs. 1 lakh after
retirement they should have a corpus generating Rs. 1.5 lakh of which Rs. 50,000 can
be reinvested in the corpus to provide for inflation in later years.
Case study: Retiree
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Mr. Tarun Malhotra (65 years)
Ms. Anuradha (60 years)
Present assets
Cash in bank: Rs. 18 lakh
Fixed Deposits (FD): Rs. 21 lakh
Own house: Rs. 80 lakh
Post office schemes: Rs. 4 lakh
Plots of land in Delhi: Rs. 18 lakh
Private Equity (PE) fund: Rs. 12 lakh
Equity mutual funds: Rs. 1 lakh
Milestones
The couple is looking to use their existing holdings to have a comfortable retired life.
Their lifestyle spend is Rs. 35,000 per month. They are evaluating the option of
spending on 2-3 foreign vacations in next 5 years each costing Rs. 3 lakh.
They are also keen on bequeathing their wealth to their two granddaughters in equal
share. Retirement planning and portfolio building
The income requirement of Rs. 4.2 lakh per year in the current year requires Rs. 90
lakh when budgeted for inflation in the next 20-25 years.
The existing assets add up to Rs. 74 lakh excluding the primary residence. This is
unlikely to be sufficient when considered for the income requirement. The options for
the couple include the following
Reduce the income required per month to Rs. 30,000/-

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Take out a reverse mortgage on their primary residence after next 8-10 years
The current portfolio allocation is grossly inappropriate for retirement planning.
Following issues exist.
As much as Rs. 30 lakh out of the total investible assets of Rs. 74 lakh are in illiquid
holdings and are not generating any income. This needs to be converted into income
generating assets such as commercial property or monthly income plans
The private equity allocation is too aggressive for this portfolio. It should be
reallocated to direct equities and debt at the first possible exit from the PE fund.
As noted above, the land holdings should be converted into commercial property or a
rental yield based REIT.
At an aggregate level the portfolio needs to have two components
Income generating portion which at 8% can generate Rs. 35,000 per month in the
present year. This amounts to Rs. 45 lakh.
Inflation linked portion which keeps adding to the income generating portion every
year an amount sufficient to increase its returns to the inflation adjusted value of Rs.
35,000/- in that year
Risk management
The couple should take senior citizens health insurance and critical illness cover.
There is no need to take any life insurance. They should also insure their property.
A crucial risk that the couple should watch out for over the next few years is the
longevity risk i.e. the likelihood that their lifespan is longer than the time for which
their assets last. This may be important especially in the years in which the inflation
linked portion of their portfolio has negative or very low returns.
Milestones

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The couple will find it difficult to go for their foreign vacations unless they are ready
to reverse mortgage their property in the near future.
They should prepare a will to effectively transfer their assets to their granddaughters.

CHAPTER XI: CONCLUSION

There is no exact definition to the term Hedge Fund; it is perhaps undefined in any
securities laws. There is neither an industry wide definition nor a universal meaning
for Hedge Fund. Hedge funds, including fund of funds, are unregistered private
investment partnerships, funds or pools that may invest and trade in many different
markets, strategies and instruments (including securities, non-securities and
derivatives) and are not subject to the same regulatory requirements as mutual funds.
The term hedge funds, first came into use in the 1950s to describe any investment
fund that used incentive fees, short selling, and leverage. Over time, hedge funds
began to diversify their investment portfolios to include other financial instruments
and engage in a wider variety of investment strategies. However, hedge funds today
may or may not utilize the hedging and arbitrage strategies that hedge funds
historically employed, and many engage in relatively traditional, long only equity
strategies.

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Other unregistered investment pools, such as venture capital funds, private equity
funds and commodity pools, are sometimes referred to as hedge funds. Although all of
these investment vehicles are similar in that they accept investors money and
generally invest it on a collective basis, they also have characteristics that distinguish
them from hedge funds. Hedge Fund Investment strategies tend to be quite different
from those followed by traditional asset managers. Moreover, each fund usually
follows its own proprietary strategies.
Hedge funds have attracted significant capital over the last decade, triggered by
successful track records. The global hedge funds volume has increased from US $ 50
billion in 1988 to US $ 750 billion in 2003 yielding an astonishing cumulative average
growth rate (CAGR) of 24 %. The global hedge f und volume accounts for about 1%
of the combined global equity and bond market. Hedge funds are a growing segment
of asset management industry and increasingly becoming popular not only with high
net worth individual investors but also with institutional investors including university
funds, pension funds, insurance and endowments. Hedge funds are sometimes
perceived to be speculative and volatile. However, not all funds exhibit such
characteristics.
Hedge funds can provide benefits to financial markets by contributing to market
efficiency and enhancing liquidity. They often assume risks by serving as ready
counter parties to entities that wish to hedge risks. Hedge fund can also serve as an
important risk management tool for investors by providing valuable portfolio
diversification.
Some jurisdictions are gradually moving towards allowing the marketing of hedge
fund and fund of funds products to retail investors. Those jurisdictions have
simultaneously imposed disclosure requirements to ensure that investors understand
the complexity and associated risk of investing in hedge funds. Realizing the growing
importance of hedge funds, several emerging market regulators have opened their
markets to offshore hedge funds by providing authorization as registered foreign
investors.
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The role played by some of the large hedge funds has often been associated with
major financial crisis that took place in the 90s. However, subsequent research could
not produce robust evidence implicating the hedge funds for precipitating the crisis.
Researchers have, however, attributed the negative public perception of the role of
hedge fund managers in crisis partly to the limited information available about what
they actually do.
In view of the increasing popularity among the institutions as well as their increasing
interest in the Indian market, it might be time to provide a limited window to this
growing segment of asset management industry within the existing framework of the
SEBI (Foreign Institutional Investors) Regulations. The approach adopted in
formulating the policy suggestions put forth in Section IV of this report has been that
of transparent and regulated access with abundant caution. The suggestions are
intended to widen the FII window to allow these alternatives invest pools to our
securities markets in a transparent and orderly manner. In addition, the suggestions
also provide for adequate safety measures to address legitimate concerns associated
with these funds. The alternative invests pools if allowed to investment in Indian
markets will be a source of additional liquidity and will also diversify the pool of
foreign investments in Indian market.

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Hedge Funds

References
Websites
http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval555
http://www.isb.edu/events/industry-events/hedge-fund-industry-trendsand-careers
http://tejas.iimb.ac.in/interviews/37.php#qn-8
http://www.svtuition.org/2010/05/list-of-hedge-funds-in-india.html
http://www.karvywealth.com/wealth-management-case-studies/

Books
Hedge Funds De Mystified Frush
Hedge Fund Market Wizards: How Winning Traders Win - Jack D. Schwager

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A Study on Feasibility of Introducing Hedge Funds in India - Vishnu Gorantala
Bhoopal

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