Changing world of hedge funds

Even as regulatory authorities in India and elsewhere get increasingly concerned about the activity of hedge funds, the world of hedge funds is itself undergoing a number of changes, which have the potential to alter completely the character of the industry.

For one thing, the number of funds has grown rapidly -- as of now there are an estimated 8,000 funds managing almost a trillion dollars in resources.

One of the reasons why the industry size has grown rapidly, particularly so in investments in Asia, is that in a low interest rate environment investors are looking to hedge funds to increase returns.

But a corollary of the rapid growth has been that most surveys evidence a fall in "excess returns", i.e. over a benchmark like, say, the one-month LIBOR -- confirming, once again, that there is no way to get around the "law of diminishing returns".

This trend is also an inevitable result of the commoditisation of financial data and of fund managers using similar quantitative models to identify investment opportunities. And, with more and more fund managers employing parallel strategies, the opportunities themselves get arbitraged out.

The second major change is in the nature of the investment activity. By definition, a hedge fund was so described because its investment strategy was to take long/short positions in similar assets, the corollary being that the returns would be independent of the direction of the market.

To elaborate, a fund specialising in, say, precious metals may go long in (under-priced) platinum and short in (over-priced) gold: the under-pricing and over-pricing being relative to the historical relationship between platinum and gold prices.

The expected "reversion to mean" relative prices would allow the funds to make a profit on the portfolio irrespective of whether precious metal prices were going up or down. Indeed, the long/short strategy was the essence of hedge fund management.

In recent years, this is hardly the case and most of the funds are taking absolute, directional bets on prices. Recently, for example, they have been extremely active in convertible bonds and distressed debt. The changing character of the risk, which the funds are running does have at least some regulators worried.

Jochen Sanio, head of BaFin, Germany's chief financial supervisor, recently expressed that it was only a matter of time before another Long Term Capital Management-type of fiasco occurs -- he admitted to being "scared" of the situation.

The recent scandal involving the Bayou group, a $450 mn hedge fund, which seems to have defrauded investors of more than $300 mn, can only add to supervisors' worries.

So would the third major change: hedge funds are increasingly attracting a different class of investors. Initially, hedge funds were regarded as high-risk investment vehicles for the seriously wealthy who could afford to take the risk -- and, hopefully, enjoy the rewards.

Lately, however, the funds are not only attracting a less wealthy (merely affluent?) clientele, but also pension funds, university endowments, and the like. To be sure, such institutional investors risk only a very small proportion of their total funds in such "alternative investments".

But the number and proportions are growing and a big loss or scandal may well lead to calls for tighter regulation and oversight on the part of financial market supervisors: even some mutual funds have started following hedge fund-like investment strategies.

As it is, the International Organisation of Securities Commissions has announced a study; and the UK's Financial Services Authority has published a discussion paper suggesting closer monitoring. The US Securities and Exchange Commission has so far limited itself to registration of funds.

One also gets an impression that the distinction between private equity and hedge funds in terms of their equity investments is vanishing rapidly. For example, Cerberus Capital Management LP, a $16 bn hedge fund, controls 30 companies with aggregate revenues in excess of $30 bn and employing over 100,000 workers.

In some cases at least, controlling stakes have been acquired through a purchase of stressed debt in bankrupt companies and its conversion into equity. Hedge funds are supposed to have significant investments in perhaps a quarter of the blue-chip German companies.

They are also being increasingly active in influencing the composition of boards, management policies, etc.--acting exactly like private equity funds. (To be sure, private equity funds do not invest in other asset classes.)

Yet another change is the fact that, increasingly, large financial institutions like commercial and investment banks are entering the business of hedge fund management, thus institutionalising the industry.

Exit strategies are getting innovative: besides the traditional sales through IPOs or to another strategic/private investor, Macquarie, the fast-growing Australian investment bank, is floating mutual funds to off-load its private equity investments. And, Hedgebay has created a "secondary market" for online trading of hedge fund investments.

Private equity: If hedge funds are treading on the private equity domain, private equity funds themselves have grown in size. Recently, the car rental company Hertz was purchased by a group of private equity funds from the Ford Motor Company for $15 bn! A few other deals are also in similar 11-digit dollars.

They have made huge profits in takeover and subsequent flotation of troubled banks in Asian markets like Japan and South Korea, and also in German property. (In fact, real estate seems to be the current favourite of private equity funds with Carlyle, Morgan Stanley, Goldman Sachs and Macquarie of Australia investing an aggregate of $20 bn or so). The scale of activity has attracted the attention of regulators and recently South Korea fined five funds over $200 mn in tax cases.

Private equity investors have of course been very active lately in the Indian market as well. While there are two reasonable-sized Indian managed funds, namely those managed by ICICI and ILFS, most of the others are managed by foreign fund managers.

The aggregate amount of private equity funding already invested and available in India is estimated at around $5 bn. Pharma and auto ancillaries seem to be the current favourites. And, given the spectacular profits some investors have earned, interest in India can only increase.