At least 20 per cent of the corpus of hedge funds seeking to register in India as foreign institutional investors should be contributed by pension funds, university funds, charitable trusts, endowments, banks and insurance companies.

The Securities and Exchange Board of India on Monday announced its draft regulations for hedge funds.

"The presence of institutional investors in the fund is expected to ensure better governance on the part of the fund manager and fund administrators. Further, institutional investors may help fund managers to take a long term perspective of the market," the watchdog said.

Sebi said the investment advisor to hedge funds should be regulated investment advisors "under the relevant investor advisor Act or the fund should be registered under the Collective Investment Fund Regulations or Investment Companies Act."

Another criteria is that the fund should be broad-based, meaning it should invest in a basket of 30-40 stocks.

This stipulation arises because hedge funds, which seek absolute returns, usually invest in a few stocks that catch their fancy. Sebi's FII regulations require a more broad-based investment philosophy.

The rules also say that the fund manager or investment advisor must have a minimum three-year track record in managing funds with an investment strategy that is similar to that of the applicant fund.

"This provision is expected to allow well managed funds to access our market and at the same time, keep our markets insulated from the possible adverse effects of 'trial and errors' by uninitiated rookies," says Sebi in its draft regulations.

Incidentally since hedge funds are not regulated entities, they cannot register as an FII under Sebi's regulations.

Sebi's draft paper has recognised the fact that some hedge funds may be operating in India through sub-accounts.

Giving credence to this, the paper remarks, "It must be remembered that all sub-accounts have to be sponsored by registered FIIs who are required to be regulated entities by the relevant regulators in their home countries."

According to Sebi data, at the end of March, 2004, the total investment by hedge funds in offshore derivative instruments (participatory notes) against Indian equity is Rs 8,050 crore (Rs 80.50 billion) or about eight per cent of the total net equity investments of all FIIs.

"On the basis of market value, the hedge funds account for about five per cent of the market value of the total assets held by the FIIs in India," says Sebi.

Rationalising the need for these regulations, Sebi said that they are intended to widen the FII window to allow these alternative investment pools access to our securities markets in a transparent and orderly manner.

"The alternative investment pools if allowed to invest in Indian markets will be a source of additional liquidity and will also diversify the pool of foreign investments in the Indian market," Sebi added.