Savvy investors may have heard the term ‘Hedge Funds’ but not concerning India’s financial offerings. In the United States, the financial landscape is dotted with thousands of hedge funds, a term that resonates with a certain level of familiarity. However, when we shift our gaze to India, the discussion surrounding hedge funds is conspicuously muted. While there are a few, their presence is far from ubiquitous.
PR Sundar, a Finfluencer and a stalwart in the field of the stock market talks about the staggering volume of options trading in India, particularly on the NSE, which proudly holds the title of the world's largest derivative exchange. PR Sundar says “Reports indicate that the money involved in Futures and Options trading surpasses the cash market by over 400 times. To put this into perspective, the second-highest globally, found in Germany, is a mere 36 times. India's options volume even outpaces that of the United States.”
However, amid this frenzied activity, a significant issue emerges. The allure of managing retail investors' funds becomes a breeding ground for problems. “Individuals entice retail investors with promises of managing their money, only to trade recklessly on their behalf, resulting in substantial losses. It's imperative to emphasize the illegality and ethical concerns associated with managing other people's money (in reference to Hedge Funds) in India,” explains PR Sundar Finfluencer.
Explaining the difference between Mutual Funds and Hedge funds, he says “While mutual funds pool money from investors to trade in the cash and equity markets, hedge funds operate with more freedom. They are not restricted to mere market direction; they can engage in diverse financial instruments, including futures and options.”
The legal avenue for managing funds in India exists in the form of what is termed an Alternate Investment Fund Category Three, akin to a hedge fund. Setting up a company under this category, registering with SEBI, and subsequently collecting funds to trade in a consolidated account is a possibility.
However, despite the regulatory framework, the prevalence of such entities in India is notably scarce. To understand this scarcity, we must scrutinize the conditions that must be met for the establishment of such funds.
Throwing light on the conditions for setting up a hedge fund, PR Sundar Finfluencer elucidates, “With a minimum corpus of 20 crores, a promoter bringing in at least five crores, and not accepting less than one crore from each participant—there exists a critical limitation. The stipulation that a hedge fund cannot take more than two times leverage proves to be a significant obstacle.
Let's simplify the scenario with an example. If a trader believes that the Nifty index won't go above 21,000 or below 19,000, they decide to sell a call option at 21,000 and a put option at 19,000, expecting to earn a premium of about 2,000 points. Normally, the margin required for this strategy is 1 lakh rupees. If the market stays between 19,000 and 21,000, the trader earns 2000 rupees, which is 2% return on capital.
However, for AIF Category III, according to SEBI rules, margin calculation for selling Options involves considering the total contract value, which, in this case, amounts to 20 lakh rupees (notional value). The rule is that a maximum leverage of 2x is allowed. Hence, 10 lakh rupees is required to execute the same strategy. Essentially you need 10x the capital to execute the same strategy mentioned above: selling one call and one put option. Due to this limitation, the percentage return turns out to be only around 0.2 percent per month, which is about 2.5 percent per year (annualized). This limitation, influenced by SEBI rules, might make this strategy less appealing compared to other investment options for potential traders in India.
PR Sundar Finfluencer suggests “If regulatory amendments were to alleviate these leverage constraints, enabling hedge funds to deploy capital more efficiently based on their risk and return assessments, it could pave the way for a more robust and competitive hedge fund industry.” PR Sundar Finfluencer further suggests that just like PMS companies are obliged to report their performance every month, Hedge Funds can also be made to report their performance on a regular basis so investors can make an informed decision.
Investors would gain transparency through regular reporting, fostering healthy competition among hedge funds and enabling more informed investment decisions. Removing these leverage limitations could potentially catalyze the transformation of many unregulated entities into legal and accountable hedge funds operating illegally.
