image credits: Billions
Hedge funds are defined as a pooled investment vehicle that can use complex market strategies and risk management techniques to improve profit margins for investors. These funds can use leverage, short-selling, and derivatives trading to "hedge" their equity portfolio i.e. protect the portfolio from downside risks. SEBI considers these funds as AIF Cat-3 (Alternative Investment Funds Category-3)
While there are plenty of massive and successful hedge funds in the United States and European Union, there are very few hedge funds in India, which are also unheard of. It's important to understand why Indian markets do not have more hedge funds and why it may be important for Indian investors to have the option of hedge funds.
Short positions on equities are intraday only.
The biggest restrictions in the Indian share markets remain the fact that shorting can be done in the spot market only on an intraday basis, contrary to the US and European stock markets. All short positions take at any time during the day have to be compulsorily squared off by the end of the day before the market closes.
This restricts the opportunities that hedge funds have to short stocks that they feel may decline over multiple days. Of course, the alternatives will be to short the futures, buy put options or sell call options of that stock. But since these derivatives have an expiry date, and options, in particular, tend to expire and become worthless, derivatives are not as good or convenient an instrument to hold bearing views in a market compared to directly shorting the stock.
High requirements to start a hedge fund
SEBI states that any fund that wants to register as an AIF Cat-3 in India needs to have a minimum corpus of 15 crores to be able to start a hedge fund. This makes it incredibly difficult for the poor and middle-class to start a hedge fund on their capital.
Lack of active participation in the stock market
Out of 1.35 billion Indians, only around 1.2% of the population invests actively or passively in the stock market, compared to almost 55% of all Americans in their stock markets. This level of participation is extremely low to have an ecosystem that can actively encourage students and youngsters to dream of running a hedge fund in India. A massive part of the population still feels the stock market is a casino and people only go to the markets to lose money.
Extremely strict regulations for hedge funds
Insane taxation laws for hedge funds in India have made running a flourishing business a major headache. A tax of nearly 33% of income from investments has kept assets managed by hedge funds in India under $1 billion. Also, SEBI states that hedge funds can only take a maximum of 1x leverage (if its corpus is 100 crores, they can take leverage of another 100 crores maximum) for investments and will be taxed on that accordingly too.
Why encourage hedge funds?
It is important to understand the positive effect of hedge funds and why SEBI should look to improve regulations to ensure easier operations for hedge funds.
Similar to institutional investors, hedge funds can provide much-needed liquidity in the market that can help in easier transactions for other retail traders also.
Keep companies in check
Hedge funds tend to have the ability to see what retail investors cannot see and take incredibly risky trades that most people cannot. As a result, they have the power in their hands to call out any discrepancies they see while making profit-taking trades that match their finding.
For example, hedge fund manager Michael Burry was one of the first people on the entire planet to realize that there would be a global financial crisis in 2008, much before even the Chairman of the Federal Reserve of the United States of America. Even Bill Ackman's war against Herbalife is a fantastic example to highlight the above point, where he publicly called out the company for its supposed Ponzi scheme.
Can generate above-average returns for clients
Unlike mutual fund managers who are under pressure to generate returns from their stock investments, hedge fund managers can generate returns much higher than the market did over a period using complex and sophisticated strategies outside buying and holding equities.
In the Michael Burry example, his fund 'Scion Capital' shorted the housing market and was able to generate a mind-blowing return of 489% for the investors of his fund, during a period where the market itself returned 4% over multiple years.