India hedge funds outperform, but investors remain sceptical

As the Indian markets have come back into form, the smart money chasing India has raked it in.

India-specific hedge funds reported their ninth consecutive month of positive returns in October. Long/short equity funds, which make up a bulk of the India-specific funds, are up 47% year-to-date and have outperformed the S&P BSE Sensex by almost 16%, reported hedge fund tracker Eurekahedge, earlier this week. A look at data over a longer period tells you that 2014 is on track to be the best year for Indian hedge funds since 2009, when such funds had generated returns of 50%. However, in 2009, the hedge fund community had underperformed the Sensex, which had returned 81%. So, in some ways, 2014 may prove to be better for India-specific hedge funds than even 2009.

Two things seemed to have worked in favour of the funds. First, it seems most of them took long India positions earlier in the year, which helped them capture the full upside in the markets. With elections coming up in May, there was still some uncertainty on which way the markets would go at the start of 2014. But funds that got in early in the year and bet on a strong verdict in favour of the Bharatiya Janata Party have been rewarded amply. The second factor that has worked for all foreign investors, hedge funds included, is the stable currency.

Taken together, these factors have meant that India-specific hedge funds have outperformed not just the Indian benchmarks but also their global peers. As a comparison, global hedge funds posted negative returns for the second month in October and so far this year; global hedge funds are up just 3.47%, shows the Eurekahedge data.

That’s the good news. Now the not-so-good news.

While Indian hedge funds may have performed well this year, investors are hardly rushing in to put money in these funds. Neither are fund managers scrambling to set up new funds. And there are good reasons for that.

Many investors got their fingers burnt while investing in India-specific funds in the past. If you look at returns of such funds in comparison to Sensex returns, the funds have underperformed in most years since 2008. In the years during which Indian market has fallen, India-specific funds have fallen in tandem. In years during which the Indian markets have gained, hedge funds have often not gained as much as the benchmark.

Investors, then, are perfectly justified in being sceptical about just how smart the smart money is.

This skepticism has showed up in the assets under management (AUM) of such funds, which remain far below peak levels. In 2008, India mandated hedge funds had $5.2 billion under management. This fell sharply after the bruising losses seen that year and have failed to recover since. As of the end of October, AUMs stood at $2.9 billion. While this was an increase over the $2.5 billion at the end of 2013, most of it was due to valuation gains, said Mohammad Hassan, analyst at Eurekahedge Pte Ltd in Singapore. Hassan estimates that actual fresh inflows have been under $50 million. A pittance compared with the money that flows in and out of the global hedge fund industry on a monthly basis.

One reason for this, said Hassan, is that investors still prefer to diversify and may choose to take exposure to Indian equities via diversified global funds or Asian specific funds. This may have tempered gains in an up-year like 2014 but it would probably help investors even out losses in a bad year.

Another reason appears to be the high volatility seen across India-specific hedge funds.

Annualized volatility across India specific funds since 2009 has been close to 20% compared with the 5% annualized volatility across global funds and the 9% seen across Asia ex-Japan funds. This is not surprising given that Indian markets are still relatively shallow and tend to swing sharply based on inflows of foreign money. The participation of long-term steady money in the Indian markets has always been thin and hence volatility has remained high. To be fair, the past five years have also been particularly turbulent due to global and domestic factors, which are now well documented.

So, while India-specific hedge funds may have earned their ‘smart money’ tag this year, it seems investors want to make sure that the smarts stick for more than a year, before they turn over their money to these funds.

Ira Dugal is assistant managing editor, Mint.