An Introduction to Hedge Funds:
Hedge Funds, simply put, are financial instruments that require lots of funding and investment from financiers and investors alike. Mutual funds and Hedge Funds are similar in the sense that both require capital from a large number of investors. Investment in both of these funds requires the assistance of a fund manager at a predetermined fee. However, an investment in mutual funds is much smaller in scale and the main emphasis is on the reliability of the returns. Investment in hedge funds is a high risk game and it involves investments where the risk factor is usually high. The chances of a high rate of return are also not guaranteed due to the risk of such investments. This is a defining characteristic of the hedge fund industry.
The term ‘hedge’ means to protect or safeguard something. Under the investment under hedge funds, there is funding and investment from many investors. These returns are then invested in both domestic as well as international markets. Accredited investors are usually associated with hedge funds. These are investors who are not registered with any financial institution and deal with Securities. These include various business entities and investors, people with a high net worth and pension funds as well[1].
Hedge funds are also instruments that protect against market risks[2] as well. Investment in hedge funds is also highly dynamic and it keeps changing from time to time. The major factor behind the low rate of return in hedge funds is probably due to the inherently high risk nature of the investments. Generally, only those individuals who have a sound financial position are in a position to deal with the ever changing and the risky nature of this industry. This becomes an essential opportunity for investment lawyers to understand how Securities are protected against market risk.
A more precise definition of a hedge fund was given by the Securities and Exchange Board of India, who defined hedge funds as “employs diverse or complex trading strategies and invests and trades in securities having diverse risks or complex products including listed and unlisted derivatives.” [3]
In the Indian context, during the on-going COVID-19 pandemic, the hedge fund market grew by leaps and bounds. A global hedge fund tracker named Eurekahedge showed data which was represented by the Eurekahedge India Hedge Fund Index came down by only about 10.57%. When this figure is compared to Sensex coming down by 23.05%, this performance seems commendable. Although this Hedge Fund Index declined and underperformed in April and June as compared to Sensex, this is encouraging for a market that seems to thrive on risk and volatility. The Indian Hedge Fund Market has outperformed their peers in other emerging markets as well[4]. Another top Indian hedge fund, True Beacon One has become a prominent name of sorts in the Alternative Investment Fund category, bettered NSE Nifty 50 by about 29%, making one of the top performers among local peers[5]. So, the hedge fund industry and market certainly have a long way to go and despite being associated with a volatile market, they have performed well amidst exceedingly challenging times. This trend has also continued abroad as well, with 11 hedge fund traders from across the U.S, the U.K, Europe and Singapore have managed to perform really well during this pandemic[6].
Characteristic Features of the Hedge Fund Market:
The SEBI has also classified hedge funds under ‘Category III’ as Alternative Investment Funds. Generally, only those individuals or institutions that have a high risk bearing capacity invest in hedge funds. The hedge fund market is a risk filled market where the exchange of securities (buying and selling of securities) takes place amid fluctuations and volatility in the market. As a result, risk averse organizations or individuals should try and avoid investing in this market. Investment lawyers play an important role in ensuring that their clients are well-aware of the legal and financial implications that would follow.
Hedge fund investments are targeted for long periods of time. They also have a lock in period, where the money which is invested in a hedge fund should be locked in for a period of at least one (1) year before it is redeemed. Therefore individuals who have a high liquidity should look to invest in mutual funds instead. Only financially secure individuals who can afford to invest in hedge funds should look to invest in hedge funds.
The hedge fund market is a rather fledgling one. It is relatively young and does not have a proper recognition by the law. Therefore, the practical aspect of dealing with it, especially from the point of view of legal compliance, is an important function for investment lawyers to play in this market.
Some of the characteristic features of the hedge fund industry/market in India are:
- This market is suitable for accredited investors who are financially well off and who can afford to invest in a risky market such as this. The minimum amount for investors who invest in this market is about Rs. 1 crore[7].
- Hedge Funds have a varied portfolio of investments. Investments in many sectors are made in the hedge fund industry. Some examples include: real estate, investment in stocks, bonds etc.
- Hedge Funds are far less controlled and regulated in India as compared to mutual funds.
- The hedge fund industry follows a market neutral trend. This means that returns on this market can go either way. This is one of the reasons as to why this market is proven to be risky.
- Another feature of hedge funds is that they invite a higher amount of fees. The hedge fund industry attracts a higher amount of fees in terms of asset management and performance fees. For example: 2% of the total assets are taken as an expense fee and a further 20% is taken as total returns on performance. This is considered to be expensive as compared to other modes of investment. However in India there is no fixed amount for this.
The Legal Regulatory Aspects of Hedge Funds in India:
Every lawyer interested in this field must be well aware of the kinds of regulatory mechanisms in place that govern the rights and obligations of investors and financial institutions in the Hedge Fund market.
As far as hedge funds are concerned, there is no definite legal provision that governs their functioning. In the introductory chapter of this paper, there was reference made to the Securities and Exchange Board of India (SEBI). SEBI provides some guidelines as well as rules and regulations that delve into hedge fund management. In 2012, the SEBI (AIF) Regulations were introduced[8]. These regulations dealt with alternative investment funds (AIF) as well as their operation and their establishment.
Under these regulations, under category III, there is a reference which is made to hedge funds which was discussed earlier. Under categories I and II, funds such as infrastructure funds (in Category I) and debt funds (in Category II) are commonly found. The funds that come under these categories are either funds that need incentives from the government, funds that will not undertake leverage or any borrowing other than that which is needed to meet day to day needs and funds that could use leverage in listed or unlisted derivatives[9]. The nature of these funds however is only meant for the short term, though under these regulations, these funds can be either open ended or close ended funds. Before this regulation was created, there was no provision that regulated open ended funds and this task was performed by portfolio managers under the ambit of the SEBI (Portfolio Managers) Regulations which was enacted in 1993[10].
A committee called the Alternative Investment Funds Policy Advisory Committee was also established by the government in March 2015 and had appointed N.R. Narayana Murthy as its chairman[11]. The purpose behind setting up this committee was to study the development of alternative investment in the future and also to examine the possible hurdles and roadblocks that may affect the development of alternative investment funds, in addition to examining the functioning of start-ups in India. The committee had submitted three sets of recommendations in January, 2016, November, 2016 and in January, 2018. The committee was also revamped by SEBI in 2018[12].
It is also important to understand the regulatory measures that the SEBI places on these alternative investment funds. Investors who invest in these funds under Category III are required to submit disclosures as to the risks involved and how those risks will be mitigated. Some disclosures include: a) the risk which is present at the funding level, b) the level of risk which is involved in foreign exchange, c) the risk of the investee’s reputation, and political, technological and social changes[13].
Apart from this, SEBI also closely monitors the pricing of these funds. According to the SEBI regulations, it is essential that when the net asset value is calculated, it is not dependent and is regardless of the fund management of various alternative funds. This value of this net asset must be disclosed to the investors quarterly and these disclosures must be made for both open and close ended funds[14].
That the SEBI has stronghold measures to deal with practices of money laundering and insider trading is also important to know. Mutual funds and hedge funds are all governed by legislations such as SEBI (Prohibition of Insider Trading) Regulations 2015 and the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations 2003[15].
Any malpractice committed by a person who invests in such funds will be penalized by these legislations. According to the SEBI guidelines, full and material information must be disclosed to the investors, as this ensures transparency. Therefore all kinds of financial information and information related to risk management, operational information etc. need to be revealed to the investor. Any information about the fees that are charged to such funds must also be revealed. Any inquiry about legal action etc. must be entertained and adequate information must be provided about the same. SEBI also provides information about short selling of securities in instances of lending and borrowing. The regulations of 2003 and 2005 apply to this as well. These funds are also marketed through the means of a private placement. Institutions such as banks and individuals having a high net worth are recipients of such funds. One must remember that foreign funds can’t be marketed in India.
Another important aspect of this is the concept of restrictions. This means that there are no restrictions on local investors who invest in these funds. According to these regulations, an investor must invest at-least Rs. 10 million and employers and managers of such funds must invest at-least Rs. 2.5 million. Payment of performance fees by such employers and managers is generally exempted[16].
Conclusion:
The hedge fund market is still an emerging market in India and is still finding its feet in the financial market. While it is a high risk market and a high value one as well, the example of the success of Indian Hedge Fund firms such as True Beacon might give young businessmen and entrepreneurs the inspiration to delve into this market. Their success is a well-crafted one and is not accidental.
This growth is evident from the fact that the industry has begun to witness new changes and growth that were initially inspired by a group of hedge fund managers including George Soros, and Michael Steinhart[17] who brought about a much needed stability to the global market. In spite of tough market conditions, they managed to boost the growth of the industry by around 50%. Today, new age managers prefer the higher fees and the greater amount of flexibility that came about with the hedge fund market, making it a viable opportunity for young lawyers to consider as well.
One must be well aware of the different investment strategies that are present under hedge funds, and the legal and regulatory aspects of the hedge fund market in India.
[1] “Hedge Funds & How They Differ from Mutual Funds”, cleartax, https://cleartax.in/s/hedge-funds.
[2] “Hedge Funds”, paisabazaar, https://www.paisabazaar.com/mutual-funds/hedge-funds/.
[3] Ibid
[4] Sachin P Mampatta, Indian hedge funds lag market surge amid Covid spike and lockdown, Business Standard July 22, 2020, https://www.business-standard.com/article/markets/indian-hedge-funds-lag-market-surge-amid-covid-spike-and-lockdown-120072201435_1.html
[5] Nupur Acharya, Ronojoy Mazumdar, Top-performing India hedge fund says stocks have risen too fast, The Economic Times, August 20, 2020, https://economictimes.indiatimes.com/markets/stocks/news/top-performing-india-hedge-fund-says-stocks-have-risen-too-fast/articleshow/77645939.cms
[6] Bloomberg News, Eleven Hedge Fund Traders Scored Big During Worst of the Crisis bloombergquint.com, May 19, 2020 https://www.bloombergquint.com/business/these-hedge-funds-beat-the-coronavirus-driven-market-collapse
[7] Supra, Refer to Footnote 1
[8] Anubhav Pandey, Legal Framework for Hedge Fund Regulation, IPleaders (August 24, 2017) https://blog.ipleaders.in/legal-framework-hedge-fund-regulation/
[9] A BRIEF HISTORY OF HEDGE FUND REGULATIONS IN INDIA All About Alpha (January 15, 2017) https://www.allaboutalpha.com/blog/2017/01/15/a-brief-history-of-hedge-fund-regulations-in-india/
[10] Supra, Refer to footnote no. 8
[11] Supra, Refer to footnote no. 9
[12] SEBI revamps panel on alternative investment, The Hindu Business Line (July 6, 2018) https://www.thehindubusinessline.com/markets/sebi-revamps-panel-on-alternative-investment/article24349202.ece
[13] Supra, refer to footnote no. 9
[14] Supra, refer to footnote no. 12
[15] Ibid
[16] Ibid
[17] Alan Rappeport, A Short History of Hedge Funds, cfo.com, October 24th, 2020, https://www.cfo.com/banking-capital-markets/2007/03/a-short-history-of-hedge-funds/
YLCC would like to thank Dylan Sharma for his valuable inputs in this article.
