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The Draft Report of the Committee on Financial Sector Reforms headed by Professor Raghuram Rajan was issued for comment in April 2008. Among the proposals that the high-level committee made was the introduction of domestic hedge funds. The committee feels that, “The presence of hedge funds would induce greater competitive pressure for other regulated fund management channels such as mutual funds.”

This week’s article discusses the benefits of introducing hedge funds in the Indian market. It shows how hedge funds could improve asset price efficiency. Besides, such funds, by virtue of their diverse investment styles, could provide investors an opportunity to enhance their risk-adjusted portfolio returns.

Of different genreSuppose a long-only (mutual fund) manager and a hedge fund manager both have a negative view on SBI, a positive view on HDFC Bank and a neutral view on ITC.

Long-only active managers will buy ITC in the same weight as their benchmark index, may overweight HDFC Bank and may not take any exposure in SBI. There is a reason for such a strategy. Active managers strive to beat their benchmark index. But they do not take too many active bets, lest their bets go wrong. Often, active funds tail the benchmark index with few active bets. Importantly, such managers cannot short-sell to take advantage of their negative view on a stock.

Hedge fund managers’ do not suffer from such constraint. In the above example, the hedge fund manager may overweight HDFC Bank, short-sell SBI and not take any exposure in ITC.

Better still, to neutralise any market risk, the hedge fund manager may buy HDFC Bank and short-sell SBI in such a way that the market risk in HDFC Bank is offset by short-selling SBI. Often, neutralising market risk on a portfolio would mean short-selling Nifty futures.

Exploiting price inefficiency

Hedge funds identify mispriced assets and exploit any price inefficiency. One way to do this is to employ statistical arbitrage.

Suppose a hedge fund manager finds that combination of one share of HDFC Bank and two short shares of SBI (1HDFC – 2SBI) has a stable statistical distribution. If the “spread” wanders far away from its mean, a hedge fund manager would set-up this strategy with a view that the “spread” will tighten. Such relative-value strategies can help arbitrate away asset price inefficiencies in a “normal” market.

Besides, hedge funds employ strategies to arbitrage price differentials between the derivatives and the spot market. Suppose a stock is trading at Rs 1,480 in the spot market. Assume that the hedge fund manager, based on her proprietary model, believes that the futures price should be only Rs 1,470 against its current market price of Rs 1,510.

The fund manager will short the futures contract and simultaneously buy the stock in the spot market. The trade will be profitable as long as difference between the spot price and the futures price is less than Rs 40.

As more hedge funds exploit such price differentials, disconnect between the spot and derivative markets could gradually reduce. And that could attract long-term hedgers to the market.

Higher risk-adjusted returns

Hedge funds create value for investors through their diverse investment styles. Here are some examples.

Relative-value strategies such as fixed-income arbitrage and market-neutral style strive to back-out beta exposure and provide alpha returns. Such strategies typically carry lower volatility than government bonds but generate higher returns. They, hence, act as returns-enhancers when combined with a bond portfolio.

The long-short investment style (such as 130 per cent long position and 30 per cent short position in equity) is a high-risk high-return strategy. The volatility of this strategy is lower than that of the traditional equity strategy. This strategy, hence, acts as return-enhancers when combined with equity portfolios.

The managed-futures investment style primarily takes exposure in commodity futures. This style acts as a risk-diversifier for an equity portfolio.

Of course, there are risks with such investments. Hedge funds typically employ high leverage. This causes a systemic risk in the event a fund folds because of high drawdowns. Besides, monitoring such managers is important because many of them may charge alpha fees for beta exposure.

It is not surprising that the committee has recommended that hedge fund investments be offered only to those who can invest Rs 1 and above. A similar such rule exists in the US.

Conclusion

It is important to understand that arbitraging price inefficiencies does not mean that hedge funds will prevent formation of market crashes or asset price bubbles. Hedge fund managers can be as irrational as the professional long-only managers and investors.

Yet, the introduction of hedge funds will be a welcome move to the Indian markets for two reasons — such funds can provide higher risk-adjusted returns for investors and can facilitate better asset price efficiency.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

Contrarian investing is a proven way of finding multi-baggers and generating great wealth in the long run. Simply put, a contrarian investment strategy involves buying stocks which have fallen out of favour with the market for some reason or the other. It could be that the market is taking an exaggerated view of the ills plaguing a stock or even the industry it belongs to, or that the markets are focussing on the short-term negatives while ignoring the longer term fundamentals.

The essence of this style of investing is to buy good quality shares at bargain prices, the prerequisite being, the stocks under consideration must be sound and stable large-cap companies backed by solid fundamentals and having a good past history of adding shareholder value.

Consider capital goods stocks in 2003. Stocks such as BEML, BHEL, L&T and many others were available at a fraction of today’s prices. Investors who had the foresight and vision to invest in such stocks at that point would be having 10, 15 or 20 baggers on their hands. It’s not as if these companies were available at depressed valuations for a small period of time. In fact, they quoted at bargain prices for quite a length of time and presented ample opportunities for investors to enter these stocks. The logic behind investing in such companies would have been that they were high quality companies backed by good managements and having solid assets on their books. They had pedigree, market standing and decades of experience. It was simply a case for investing and patiently waiting for the investment cycle to turn around.

Many investors not only missed the bus, but also sold off some of the shares held in their portfolios for long periods of time.

My argument is that for earning the highest returns, an investor needs to identify stocks which have been hammered to their lows, and analyse whether such low valuations are justified given the history, management quality, nature of business, quality of assets, size of business and future prospects, etc. Then, if the investor is convinced that the business is not going to disappear any time soon and simply awaits a change in the business cycle to see better days, he needs to go ahead and invest in it. Market volatility may yet take the stock price lower, but one should have conviction that the buy is backed by solid reasoning and fundamentals. Panic should not creep in at this point; rather, the fall should be used to buy more of the stock.

Generally speaking, the same analogy could be applied to the entire stock market or any other asset class. For instance, an investor could have taken a contrarian call on the Indian markets in 2002 and bought stocks, seen them go down further until 2003 and then increase by more than 500% in subsequent years. The gains made would have more than compensated for the initial notional decrease in values.

The writer is proprietor of Capital Management Services. He blogs at www.investologic.blogspot.com and can be reached at mknaik99@rediffmail.com.

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The market moved in to a bit of a corrective mode recently with higher inflation numbers coming out week after week and also due to some amount of bounce in crude prices once again, which breached the USD 120 per barrel mark recently. The bearish stance of the FIIs on Indian equities also weighed on the market. FIIs, until now, have been net sellers in equities by around Rs 1000 crore in August. Mutual Funds too have been net sellers in equities in August by a little less than Rs 1000 crore as per figures available on August 22. 

 Inflation based on the wholesale price index stood at 12.63 per cent for the week ended August 9, which is the highest in the past 16 years. It is being anticipated that the RBI would hike interest rates further in its forthcoming meeting on August 30 and inflation would peak out in the range of 13 – 13.5 per cent. The expected rate hike would most probably be the last one in the current cycle. Any further rate hikes henceforth in the near term could materially impact industrial and economic growth, which the RBI would not want to happen. 

In the Q1 FY09 corporate results, there were already signs of an impact on the bottom lines due to high raw material and input costs and higher cost of capital. An earnings growth of 11-13 per cent in FY09 is being projected. The market is currently trading at 14 and a half times FY09 forward earnings and looks fairly valued. However, the valuations look appealing in terms of FY10 estimated earnings and investors initiating long positions can expect a 20 per cent upside from the current levels. 

The global cues in the last fortnight have not been very positive. There was news that the government would have to nationalize bond insurers Fannie Mae and Freddie Mac, which are among the largest bond insurers in the US. The two institutions, which have a mortgage portfolio of more than 5 trillion US dollars, have been badly hit by the credit market crisis that the US is undergoing. Their nationalization would lead to a wipe out of shareholder value.

 The crude prices at sub USD 120 per barrel are now well below the all time high level of USD 147 per barrel. This is due to an increase in supply by the oil producing nations, and also due to a reduction in demand as we witness some amount of relative global economic slowdown.

In the short term the market is expected to be range bound. The Sensex could drift in the range of 14000 and 15000.

Going forward markets will be dependent upon global clues and fund flow as well from FIIs. With Left out of UPA, pace of reforms in India in the next six months will be crucial for markets as well. Any rise in crude or commodities from current levels will also put pressure on markets. Domestically inflation and IIP numbers would be of paramount importance. At current levels most of the negative factors related to slow down in economic growth, high inflation and high interest rate environment seems to be factored in and any fall from here on will be only on back of high crude and commodity prices. On the other hand any positive news on inflation and industrial production front can cause the markets to go up as we have already witnessed a decent amount of correction from the highs in the last couple of months. We recommend benefiting from the expected volatility by buying into fundamentally sound & beaten down stocks at current and lower levels.

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GOLD exchange-traded funds (ETFs) are feeling the pinch due to the shortage in physical supply of the bullion. Gold ETFs are open-ended mutual fund schemes that are backed by units of physical gold (0.995 purity).

The recent drop in gold price has led to a flurry of demand, which bullion banks were unprepared for. This has caused a shortage in supply.

As a result, the demand for paper gold has risen and ETFs are trading at a premium of between 35% and 5% to the spot price of gold in the last few weeks.

“There is a shortage for physical gold in the market, which is reflecting on ETF prices. The demand is growing and our ETF holdings are growing at 10% every month,” said Rajan Mehta, executive director of Benchmark Gold ETF.

Benchmark Gold BeES currently has a total holding of 2 tonne of gold. The net asset value, which indicates the price of the underlying asset, is Rs 1,176.59 per unit (one unit = 1 gram) on Tuesday.

Similarly, the other liquid ETFs, UTI Gold ETF, Kotak Gold ETF and Reliance Gold ETF are quoting NAVs of Rs 1,182.31, Rs 1,178.5 and Rs 1,192.72 per unit each, respectively.
The spot price of standard gold in Mumbai is quoting much lower at Rs 11,470 per 10 gram (Rs 1,147 a gram).

Analysts tracking gold pointed out that even the futures market has been trading at a price closer to the spot market between Rs 11,200 and Rs 11,350 per 10 gram. “Unless gold ETF value falls, narrowing the gap with the spot price, it would not be lucrative for the investor,” said Kotak Commodities associate vicepresident Si Kannan.

Imports of gold into India are down 56% in July compared with last year, at 30 tonne. India, the largest consumer of gold, had imported 68 tonne in July 2007.

Kotak Mutual Fund products vicepresident and head Lakshmi Iyer said: “The volatility in gold prices over the last few days has predominantly driven the demand for ETFs.” She said there was constant capital creation, but they would have to wait to see how the ETF has performed at the end of the month as mark-to-market losses might have to be considered. Kotak Gold ETF had holdings worth Rs 45 crore, or nearly 380 kg, at the end of July. The total holdings in Indian ETFs are presently around Rs 630 crore.

With equity markets descending from their record highs, several investors want to know if this is the right time to invest in equities. More importantly, they would like to know if markets have bottomed out.

As regards the former, it can be safely stated that the markets are attractively poised in terms of valuations. So does that mean investors across the board should get invested in equities? Not really. Only investors who can take on the risk associated with an equity investment should consider getting invested. Also, investors should be willing to stay invested for the long haul (at least 3-5 years).

Then again, investors must honestly evaluate if they are competent enough to directly invest in equities. If not, they would be better off opting for the mutual funds route and thus bank on the expertise of the fund manager and the fund house. As for the question about markets having bottomed out, to be honest, we are not equipped to predict when that will happen.

However, for serious long-term investors, we believe that is an irrelevant parameter.

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