Hong Kong: Hedge funds are finding India the toughest Bric country to beat consistently in falling stock markets, raising questions if the high fees they charge for all-weather outperformance is justified.
Profiting from short-selling, or when share prices fall, is a key factor that differentiates them from traditional funds and allows them to charge much higher fees.
But India-focused hedge funds have fallen more than the country’s benchmark Sensex index in nearly one third of the 40 negative months recorded by the index since 2002, a study by the New York-based industry tracker HedgeFundNet (HFN) shows.
By comparison, Brazil and China funds have underperformed only in two and three down months, respectively, although their benchmark indices have recorded more down months than India. Russia funds have underperformed only in two down months.
The failure to deliver in down markets can hurt growth prospects and make investors question the performance fee of about 20% and management fee of 2% charged by hedge funds. Traditional funds only charge management fees.
“I think the Indian hedge funds really have to re-prove themselves,” said Richard Johnston, head of Asia-Pacific at hedge fund advisory firm Albourne Partners.
Grouped under the ‘Bric’ moniker coined by Goldman Sachs’ Jim O’Neill in 2001, Brazil, Russia, India and China have gained popularity in recent years as an asset class.
Reliance on relatively more volatile mid-cap and small-cap stocks to generate outperformance, long portfolios and limited shorting opportunities are factors behind the underperformance of India-focused hedge funds, portfolio managers said.
“Part of the reason is structural because India does not have dedicated stock lending mechanism to facilitate shorts,” said Mumbai-based Vijay Krishna-Kumar, advisor to TCG IndiaStar hedge fund that has about $50 million under management.
His fund, founded by ex-Soros adviser Purnendu Chatterjee, was down 1.64% in January, compared to the 10.6% drop in India’s benchmark share index that month.
Fund managers also lack experience in shorting, or betting on falling share prices.
“Stylistically, Indian managers don’t know how to short,” Kumar said. “They are usually from the mutual funds world so they don’t really understand the short side very well.”
India-dedicated hedge funds managed about $3.9 billion at the end of June 2010, some $5 billion short of their pre-crisis level, after losing about 50% in 2008, according to data from industry tracker AsiaHedge.
With about 5,000 listed firms and only about 650 of them covered by research analysts, according to data from Thomson Reuters StarMine, mid-caps in Asia’s third-biggest economy still present a fertile hunting ground for tomorrow’s bluechips.
However, while they have rewarded funds in a booming market and lured portfolio managers to bet on them, mid-caps have also led to sharper losses in falling markets.
For instance, the BSE Mid-Cap index lost 67% in 2008 when the Sensex was down 52%. So far this year, the mid-caps have lost almost twice the loss in large-caps.
“Traditionally hedge funds have obtained alpha by mid-cap investments in India and in a down market the mid-caps just get battered,” a Singapore-based India-focused hedge fund manager said, but declined to be named.
India has about 220 single stock futures which can theoretically help hedge fund managers short and protect the downside but often they do not cover their entire mid-cap and small-cap exposures.
“You can’t protect a multi-cap portfolio by using Nifty as a short,” the hedge fund manager said.
Most hedge funds get their exposure to Chinese stocks through the sophisticated H-share market in Hong Kong.
China also launched index futures and allowed short-selling for the first time last year, enabling investors to profit from falls in stock prices and paving the way for the emergence of hedge funds.
China, India vs Russia, Brazil
Even when India-focused hedge funds outperform in a down market, they lag other Bric peers, said Peter Laurelli, vice president of research division at HFN. But they tend to underperform by the least amount during up months, he added.
Funds focused on Brazil and Russia, countries that are more heavily influenced by commodity markets, do well in down markets but fail to show similar outperformance in up markets, according to HFN.
“...For China and India, two countries more heavily influenced by consumer demand and technology sectors, funds underperformed by the least during up-markets and outperformed by the least amount during down markets,” Laurelli said.