Sucheta Dalal :Crashing the hedge fund party
Sucheta Dalal

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Crashing the hedge fund party  

Apr 11, 2005

Leading stock indices have dropped substantially over most of last week, increasing concerns about the continued interest of global investors in emerging markets. Also, most world markets remain in the throes of uncertainty over US interest rates and the course of oil prices. While the direction of stock prices will become clearer over the next few weeks, what is of immediate concern right now is the enormous daily volatility in stock prices in our markets and the contribution of hedge funds to this market behaviour.


This is especially worrying because India has no large domestic institutions that are likely to reduce volatility or spoil the hedge fund game by taking a contrarian view.


After the initial euphoria over hefty subscriptions to domestic mutual fund offerings, it is clear that there has been little additional investment and most of the subscription has been from investors who were induced to switch from old schemes to new, by agents who earn fatter commissions on new schemes. Indian public sector banks and insurance companies are largely out of the market. And unless they develop investment expertise, and have incentives and accountability norms for those in charge of investments, it is best that they stay away.


The retail investor population remains stagnant for over a decade and even today there is little effort by the government or its regulators to understand their woes, to address issues that keep them away or to make any serious effort at increasing financial literacy in the country.


That leaves the field open to a few dubious Foreign Institutional Investors (FIIs) and hedge funds operating through FII sub-accounts, to manipulate the market at will. In the last few months, FIIs have been buying and selling in excess of Rs 1,000 crore worth of shares everyday.


But there has been no effort to study their operations or to figure out where their vast supply of shares is coming from. There is also no study by the regulator or by stock exchanges to correlate FII operations in the cash market with the additional pressure exerted through their derivative trades. For instance, anecdotal reports say the big spike of 230 points on March 31 and April 1, occurred due to a fierce tussle between genuine FIIs who wanted to close the financial year with healthy Net Asset Values and hedge funds who saw the lack of liquidity and global weakness as a great opportunity to bring the market down. Much of that two-day rise has since vanished.


Similarly, the opportunistic role of a large US-based fund in the war between the Ambani brothers also bears closer examination. This fund dumped over 70 lakh shares of the company over a two-day period last December and also sold another 50 lakh shares in the futures market. Had it not been for an uncannily timed buyback announced by the company, the shares were bound to have collapsed. Was this the behaviour of a rational investor? Why would an exiting investor jeopardise the prospect of maximising its returns? It certainly merits regulatory scrutiny.


After the Scam of 2000, the Reserve Bank of India and SEBI banned Overseas Corporate Bodies (OCBs) from operating in the secondary market. However, it is clear from anecdotal evidence and trades that plenty of FIIs (including blue chip names) are acting as fronts for rich Indian industrialists. The government has made occasional noises about trying to establish the identity of FII clients, but this has never been pursued with any seriousness. The reason is obvious. A furious bull market is invariably marked by regulatory complacency. When foreigners seemed set to continue pumping in a billion dollars every month into Indian equities, why worry about a collapse?


But the situation has turned shaky over the last few weeks. The inflows are not so fast and furious anymore and hedge funds in particular are ruthlessly seeking to exit at a profit. Hedge funds have always been shadowy operators who face little regulatory oversight even in the global market. A hot discussion on message board of The Motley Fool — a reputed international webzine — provides interesting insights into why investors and regulators should worry about hedge fund operations.


Even sticking to the milder details in this discussion, here is a consensus view on hedge fund operations. “You don’t hear much about how hedge funds work in the mainstream financial press because most of them like to keep their dealings secret. The hedge fund industry has grown to over $1 trillion in assets under management and has a major impact on the markets on a daily basis. Digging up information about them can be difficult, but I think it is important for all of us to try and understand what their impact is,’’ says Rodger Rafter (


What makes these funds different is apparently the fee structure, which gives fund managers a rich 20 per cent cut on profit with no liability or losses. They are also hugely leveraged, face little meaningful regulation and their trading strategies vary from the mathematical to the ‘very manipulative’. Also, unlike big institutional investors who look for well-capitalised companies and liquid stocks, hedge funds are apparently happy to manipulate small-cap stocks, especially biotech and pharmaceutical companies.


They also do not remain invested for long and like to book quick profits — worse, they work at boosting this profit by manipulating stocks. With one trillion dollars in play, there is a suspicion “that hedge funds are influencing markets in many unhealthy ways and are also behind an increasing number of mergers and buyouts for a wide range of dishonest reasons”.


While many hedge funds fall victim to their manipulative ways and blow up, they also damage the markets. Even if we temporarily ignore worries about a hedge fund meltdown and its implications, it is clearly time for Indian regulators to start worrying about the quality of foreign money pouring into Indian markets and incomplete information about the rapid overseas fund raising activities of companies and the various corporate exposures that are adding to risk without adequate disclosure.


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-- Sucheta Dalal