Hedge in its original sense means a barrier or a limit. The evolved meaning of the word is: a means of protection or defense (as against financial loss). Hedge funds are supposed to do exactly that. Since they are hedged, the funds should (ideally) make money irrespective of whether markets are going up or down. As the name implies, hedge funds often seek to offset potential losses by hedging their investments using a variety of methods, most notably short selling. However, the term `Hedge Fund' has come to be applied to many funds that do not actually hedge their investments, and in particular to funds using hedging methods to increase rather than reduce risk, with the expectation of increasing return. Hedge funds as a class invest in a broad range of investments, including stocks, debt, and commodities.
Hedge funds are typically open only to a limited range of professional or wealthy investors. This provides them with an exemption in many jurisdictions from various regulations. In India, portfolio inflows through hedge funds were steadily rising until recently. Last October, the Securities and Exchange Board of India (Sebi) lifted a ban on issuing the so-called Participatory Notes (PNs) as well as other caps on these instruments in an effort to pull in more foreign capital and shore up a rapidly falling Indian stock market.
The decision reverses a year-old decision under which the regulator had placed a 40% cap on Foreign Institutional Investors (FIIs) issuing PNs through sub-accounts, and had completely banned any such instruments that were based on Indian stocks or index derivatives as part of a campaign to flush out what it had labeled `anonymous investors'.
In the US, the government has recently offered a bailout package for hedge funds. Hedge funds will now be allowed to borrow from the Federal Reserve for the first time under a landmark $200 bn program intended to support consumer credit. The new program, aimed at injecting credit for consumers and small businesses, including auto loans and credit cards, will be launched in February.
The Indian stock market declines in recent times, especially the one in October last year, were spurred by hedge funds selling to meet redemption pressures. India-specific Hedge Funds (IHFs) are at the bottom of the hedge fund performance table. According to a report compiled by Eurekahedge, a leading global hedge fund researcher, the India-specific funds registered over 54% loss last year.
What leads to a plethora of these hedge funds in the first place and why are they scurrying for cover now? In recent years, there was a rise in the global risk appetite. This, coupled with the free flow of investment capital into India, created a conducive environment for hedge funds. It resulted in a virtuous cycle of asset prices going up, resulting in more capital flow into those assets. Soon, the price graphs of most asset classes started to take the shape of a parabola—the typical sign of a bubble. The main reason for the present plight of most hedge funds can be attributed to the burst of this bubble (spread across asset classes). However, hedge funds also suffer from certain structural deficiencies, which have contributed to their present plight. Some of the factors that lead to the flight of hedge funds are given below.
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