Dalal Street isn't usually great at keeping secrets. but just this once, it may have managed to excel at it. Did you know, for instance, that hedge funds-yes, those mysterious investors whom regulators love to hate-aren't just investing in Indian equities, but actually are the source of a large part of the money coming in? D-street watchers say that over a tenth of the $30 billion (Rs 1,35,000 crore at current exchange rates) that's been poured into Indian equities by foreign investors over the last three years has come from global hedge funds, and that their share is increasing. Last calendar alone, some experts reckon, of the $10 billion (Rs 45,000 crore) that foreign institutional investors (FIIs) bet on Indian stocks, as much as 40 per cent may have been hedge fund money.

Hedge funds are generally more fair-weather friends than your average FII or mutual fund (mf) because hedging against more mainstream assets, their historical raison d'etre, is no more their investment strategy. Instead, they single-mindedly chase the highest returns, turning over their portfolios faster than you can say 'invest', and can move from one market to another with great speed and little remorse. (Now you begin to see why most stock market regulators, including ours, don't like them much.) In India, the law says hedge funds aren't welcome. But the fact is, at least 40 India-dedicated H-funds have joined the party on Dalal Street, and of them 20 over the last 15 months. If their number and investments have risen, it's because of bellwether index Sensex's breakneck rise. In the year to April 26, 2006, Indian stock markets have been the third best performers among the emerging markets, next only to Indonesia and China. The Morgan Stanley Composite India (MSCI) Index gained 26 per cent last year.

Samir Arora Fund Manager, Helios Strategic The former Alliance Capital manager now runs a $158-million hedge fund focussed on India

Which are the H-funds investing in India? Mainly those focussed on India such as Pan-Asia Pacific Funds, Emerging Market Fund, and Global Equity Fund (see The Hedge Fund Line-up). A lot of the money has also come through the controversial participatory notes, which make it possible for some hedge funds to invest indirectly in Indian equities. (SEBI had cracked down on P-notes, but 35 per cent of the FII inflows last year came via P-notes.) More such money should flow in, simply because hedge funds operating in emerging markets are generating better returns compared to hedge funds on the whole. In the 12 months to February 28, 2006, the MSCI Hedge Fund Emerging Markets Index delivered 15.5 per cent in growth, compared to 10.5 of the overall MSCI Hedge Fund Composite Index. If you look at the returns for just the first two months of this year, the former, at 6.20 per cent, delivered almost double the returns against the overall index. That explains why D.E. Shaw, the world's largest hedge fund, is said to be entering India by June 2006 (it has roped in Anil Chawla, a former GE Capital honcho, to head the local operations), and UK's Absolute Capital Management has tapped Bharat Shah of ask Raymond James as an advisor for its m300-million (Rs 1,590-crore), India-focussed fund. Shah already advises another such fund, Naissance Jaipur Fund. (There's a mad scramble for hedge fund managers, but that's another story.)

Cause For Concern?

If SEBI doesn't register hedge funds, how are they able to operate in India? Are they taking advantage of some regulatory loopholes? The answer seems to be, yes. According to one stock market expert, one of the loopholes is that foreign-domiciled hedge funds that are registered and regulated by that country's regulatory authority tend to get automatically registered in India on application. Of course, the second problem is that most hedge funds don't mention the fact they are hedge funds when they apply for registration. "If there are hedge funds operating in India, then they have jumped the barrier," warns a senior SEBI official.

So, should investors worry? Yes and no. Most hedge funds are no longer pure players in derivatives, which used to set them apart. Like private equity funds and mutual funds, they handle a pool of assets. In India, too, they seem to be behaving more like mainstream institutional investors. There's very little of long-short, event-driven, multi-strategy, or fixed income and convertibles arbitrage-all typical hedge fund strategies-happening in India. "The India-focussed hedge funds are long term in nature," says the fund manager of an India-dedicated offshore fund based in Luxembourg. "The aim of most of them is to unlock the long-term growth potential of the Indian economy."

Bharat Shah CEO, ASK Raymond James UK's Absolute Capital Management is seeking his advice on its India-focussed fund

Unlike other markets where hedge funds can short sell, in India they have been investing in stocks that aren't part of the futures and options (F&O) segment. Indeed, some hedge funds are behaving more like private equity investors, taking bets for the long term. India Capital Fund, for instance, has been holding a 2 per cent stake in the State Bank of Bikaner & Jaipur for the past one year, and its patience has been more than rewarded. In that time, the stock has risen 78 per cent to Rs 4,164. Similarly, pre-ipo placement by Indiabulls Financial Services to San Francisco-based Farallon Capital has also fetched the multi-strategy fund good returns. The stock it bought for Rs 25 apiece is now trading at about Rs 277, increasing the value of Farallon's investment by Rs 72 crore.

Although the line between hedge funds and, say, MFs is blurring (partly because mutual funds are now dabbling in derivative instruments like the former), concerns remain. Says Rachna Baid, professor, Indian Institute of Capital Markets: "A lack of transparency and light regulation, unlike in the case of MFs, have been the biggest concerns surrounding hedge funds." Besides, their tendency to make "directional bets" (i.e. to bet up or down in tandem with the market direction) on assets increases market volatility. "Over the last three years, the assets under management of hedge funds as well as their reach have grown, therefore, regulators across the world are grappling with the issue of systemic risk arising from these supra-national entities," says Ajay Bagga, CEO, Lotus India AMC.

The surge in hedge fund assets globally-up 24 per cent to $1.2 trillion (Rs 54,00,000 crore) in 2005-is courtesy their investors. "Those days are gone when investors used to satisfy themselves with relative returns to the benchmark," says the fund manager of the Luxembourg-based fund. "Now they want absolute return, irrespective of the market movements." Jane Diplock, Executive Chairman, International Organisation of Securities Commission, who was in Mumbai recently, says that increasing retail participation in hedge funds is the cause of concern among regulators. "By their very definition (hedge funds) are opaque and no one knows what's going on inside the black box," says Diplock.

Starting February this year, hedge fund registration became mandatory in the US. But as Diplock points out, "with the hedge fund industry changing dynamically and no vanilla regulatory response appropriate for them, we are trying to better ascertain their risk profiles." What's clear is this: Hedge cannot be allowed to be law unto themselves; just like other market participants they have to play by the rules. And especially in India, where the regulator has no experience of dealing with them and 40 per cent of the money fuelling the stock market boom is theirs.