August 10, 2010 / 3:25 PM / 9 years ago

Bulls on parade – the strategy shifts in Indian hedge funds

(Farhan A. Mumtaz is a senior analyst at Eurekahedge Pte Ltd. The views expressed in this column are his own and do not represent those of Reuters)

Farhan A. Mumtaz, analyst at Eurekahedge Pte Ltd. REUTERS/Handout

By Farhan A. Mumtaz

“Do not repeat the tactics that have gained you one victory, but let your methods be regulated by the infinite variety of circumstances” – Sun Tzu

The strategies breakdown of Indian hedge funds over the last few years shows a major change in the industry’s approach to the market. Until the end of 2004 there were less than 20 India-focused hedge funds, and most of them were part of larger asset management groups.

These older funds were set-up by experienced fund managers who believed India had fundamental growth potential and relatively low valuations, and as such looked to derive substantial revenues from the market over the long term.

The next three years, however, saw a strong influx of new managers to the market, who were lured by India’s economic growth story.

The number of funds increased three-fold in the three years following 2004, with most fund managers choosing to employ the long/short equity strategy. By mid-2008, the number of long/short equity funds made up more than 80% of the Indian hedge fund space.

However, a noticeable trend within this group was the proclivity for a long-bias, and initially this paid huge dividends for managers as Indian markets surged in the 2005 to 2007 period. In these three years the Eurekahedge Indian Hedge Fund Index gained near 150%, matching the gains made by underlying equity markets year-on-year.

On the flip side, however, leveraged positions with a long bias also had the inherent risk of heavy losses in a downturn, which came to the fore in 2008 when markets collapsed.

The situation was further aggravated by the prevailing sentiment that India was sheltered from the turmoil in global markets, and managers were not particularly worried about the credit crunch in 2007 and early signs of a global downturn.

Furthermore, a number of Indian hedge funds had also taken up significant positions in small-caps, looking to make the most of forecasted growth. However as the financial crisis hit markets, these turned out to be the most illiquid investments with low trade volumes, and as the markets went into a free-fall, the managers were stuck with losing positions.

Amid widespread losses, averaging more than 50%, the industry was also hit by fund closures - almost a fourth of India-focused hedge funds closed shop. Not surprisingly, 90% of the closures were equity-focused funds that were set-up in the previous three years and were relatively inexperienced, while funds which were part of larger groups and had the necessary processes and risk management structures in place managed to survive the turmoil.

The post financial-crisis structure of the Indian hedge funds sector now paints a more diverse and varied landscape. The last two years have served as a culling process to weed out those funds which did not have the appropriate organisation or strategy for long-term growth.

Furthermore, with an increasing array of instruments available in the market, funds employing more sophisticated strategies have entered the space. In two years the proportion of long/short equity funds in India dropped from more than 80% to about 68% as of June 2010.

The strategic shift is also apparent in the 2010 returns of the Eurekahedge Indian Hedge Fund Index, which has outperformed the Sensex (as at end-July) by 2.5% with half the volatility, as opposed to the previous years when the returns and volatility closely followed the underlying markets.

Going forward, the trend of diversification looks set to continue through the rest of 2010, as the launch activity gears up in Asia. Increasing allocations to Indian hedge funds is also on the cards, with hedge fund investors keen to diversify from traditional regions and strategies.

As the Indian market offers an increasing number of sophisticated instruments across different asset classes, the hedge fund industry looks set to further strengthen its presence with large asset management companies starting to launch India-focused funds.

(You can e-mail Farhan A. Mumtaz at farhan@eurekahedge.com)

The above article is not intended to be a financial advisory. Readers must seek specific advice from experts before making investment decisions.

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