India – Is It For Real This Time Round?

The BSE Sensex, the benchmark of large-cap Indian stocks, has climbed vertiginously past 8,000, an appreciation of almost 80% from the troughs of 4,505 on 17 May 2004. Foreign Institutional Investors (FIIs) have poured in close to US$17 billion into the Indian equity markets since January 2004, over 44% of the cumulative foreign flows since the markets were opened to foreign investors in 1993. The Indian market is in the grip of a euphoria; often seen in the past 15 years, always holding promise, but seldom failing to disappoint. Therefore it is both natural and fair to question the nature and sustainability of the current Indian opportunity and what it holds for hedge funds.

Figure 1: Foreign Inflows and the Indian Stockmarket


A long-term Growth Story

The multi-faceted development of the Indian economy is a powerful engine for job creation and increased purchasing power, which with the catalyst of very low penetration levels of most goods and services is resulting in explosive growth in industry. With about 90% of the over one billion Indians, below the age of 60 years, the cycle of employment generation, purchasing power creation and increased consumption can continue for the foreseeable future.

India's growing stature as a recognised location for outsourcing is driving corporate earnings and economic growth. While India is an acknowledged leader in outsourced software development, the quiet revolution in outsourcing into India in fields as diverse as pharmaceuticals, contract research, clinical trials, auto ancillaries, textiles, back office processing, accounting to name just a few is less well known. Exports from India have almost doubled in the last four years and indicators are that export growth can add almost 10 million jobs over the next five years.



Figure 2: Indian Exports

Source: Government of India

India's poor infrastructure is ironically also a huge investment opportunity, given the scale on which India operates. The country has about 3.3 million kilometres of roads, over 100,000 kilometres of railway lines, over 200 airports, an estimated 138 million rural households with a significant percentage having very limited access to quality electricity and piped water. India has budgeted a spending of over US$155 billion on infrastructure development in the period 2002 to 2007, with further expenditure to follow. This will go partly towards raising the quality of existing services and partly towards building fresh capacity.

This huge spending is driving earnings for the entire spectrum of companies associated with infrastructure development. These projects are also major employment generators, with consequent feed through into demand.

Figure 3: Plan Figures for Infrastructure Investment

Source: Plan Documents and CRIS INFAC

Growth in a country as large as India is big, not just in percentages but in absolutes. The mobile phone industry in India is a wonderful illustration. In 1998, India had only about 1 million subscribers of mobile phones. India today adds about 2.5 million subscribers every month, making it one of the fastest growing markets in the world in absolute numbers! Yet mobile phone penetration is still only about 6%.

India's scale attracts global players, seeking in India an alternative base for their operations. In a recent survey, trans-national companies ranked India second only to China, in terms of attractiveness as a global business destination (Unctad, World Investment Report 2005).

Goldman Sachs in its much acclaimed 'BRICS report' (Goldman Sachs, BRICS Report 2004) has projected that given the right conditions, India can be the third largest economy in the world in less than 30 years. It is also estimated that India is possibly the only major economy capable of sustaining a 5%+ per annum growth rate over the next 50 years or so. India therefore presents investors long-term sustainable growth combined with tremendous scale. This makes India a very interesting investment theme.

The Sensex P/E of about 15 on current year earnings (Kotak Institutional Equities) are around the average levels seen for the last ten years, and with a PEG of about 0.85 the market seems fairly valued. However, the Indian market has consistently shown the ability to surprise the investor, and must be invested in for the long term.

Figure 4: 12-month Rolling Price/Earnings Ratios

Source: Kotak Institutional Equities, October 2005

Threats to India's growth

India's democratic processes while assuring some stability can be a drag on reforms, an imperative for sustaining rapid growth. Escalation of tensions with Pakistan can also hinder progress. However, with both countries integrating into global supply chains, the adverse economic consequences of conflict will minimise the likelihood of such an event. India also has the enormous challenge of creating world class infrastructure as China has done, in order to deliver sustained growth.

A Large Market with the Right Structures

The strength of the Indian legal and accounting system and the relative sophistication and transparency of the Indian equity markets are factors that help India score high among its peers.

The trading and settlement platform in India compares favourably with the best in the world. All transactions on the Indian exchanges are necessarily executed on an electronic order matching system, and settle on a T+2 basis. Settlement risk for foreign investors is minimal, due to the compulsory settlement of all trades through a central clearing house.

Among those who know, it is widely accepted that in Asia, India ranks very high on corporate governance. India has well laid out accounting standards, with strict guidelines for information dissemination by listed entities. More importantly the substance of corporate governance has also made significant progress. Discussions on creation and protection of shareholder value are not uncommon in corporate boardrooms.

With over 6,000 listed companies, a market capitalisation in excess of US$500 billion and with daily trading volumes of about US$6 billion on stocks and their derivatives, the Indian markets are not small. The Indian market has one of the highest transaction volumes in the world, with over 3 million trades being put through on a typical day.

The Hedge Fund Opportunity

India's long-term secular growth, coupled with the associated robust growth in corporate earnings, have the potential to deliver attractive returns over the medium to long term, to investors investing in this growth story.

However, India as a market has tended to surprise investors, with periods of gut wrenching and at times unpredictable volatility, interspersed with periods of relative calm. This provides an inherent opportunity to hedge funds, looking to benefit from the Indian growth story, while trying to smoothen out the returns for their investors.

Primarily an Equity Market Opportunity

Current regulations permit foreign investors relatively free access to the equity and equity derivative markets, a very limited access to the fixed income market and practically no access to other segments of the Indian securities markets. Given this, the handful of hedge funds investing into India are primarily equity focused.

Foreign investors are currently not permitted to leverage or short domestic stock. Short exposures and leveraged exposures can only be obtained through futures and options on about 120 stocks and on a set of indices. The daily traded volumes on the equity derivatives market is about US$3.8 billion per day, of which about 33% of the volume is on index futures and options. The contracts are limited to durations of one, two and three month, with the bulk of the liquidity on the near month contracts.

Figure 5: Daily Average Turnover - Derivatives Segment (September 2005)

  Index Futures US$m Stock Futures US$m Index Options US$m Stock Options US$m Total US$m
NSE 1,038 2,418 226 151 3,833

Source: BSE & NSE

Limited Strategies Possible

Given the current regulations, the strategies and tools that can be utilised by hedge funds are fairly limited. The handful of genuine hedge funds that have been set up for India – the rest are long-only funds set up in the guise of hedge funds – follow fairly similar sets of strategies for India.

  • Most funds are significantly long biased, relying on their stock picking capabilities to generate for their portfolios. Given the large number of listed, under-researched companies in India, a significant presence on the ground in India provides a distinct advantage.
  • A majority of funds create an overlay of shorts, primarily using index futures to reduce volatility in periods of higher perceived risk.
  • There is some room to create through shorts, using futures and options.
  • Smaller funds (sub–US$100 million) can also use options quite effectively in range bound markets.
  • From time to time there can be opportunities, though limited, to adopt event driven strategies, and arbitrage strategies.

The industry is too nascent to handle specialised funds adopting niche strategies. Hedge funds with significant long bias with a overlay of shorts, can handle capacities of US$150-300 million given current market volumes. The Securities and Exchange Board of India (SEBI), the Indian market regulator, is likely to open additional segments of the market, such as commodities, to foreign investors in the coming months. The regulator is also actively considering a move to permit shorting of stocks by creating an active stock lending business.


The Indian regulators realise that hedge funds can be an important source of liquidity and efficiency in the Indian markets. At the same time there is the worry of hedge funds with aggressive strategies destabilising the market.

Hedge funds investing into India are currently governed by the same set of rules that apply to other foreign investors. Foreign investors need an FII registration from SEBI for accessing the Indian equity markets. The pre-requisite for obtaining such a registration is that the FII or its investment manager needs to be regulated in a recognised jurisdiction such as the US or the UK and have an established track record. This requirement unfortunately eliminates a number of hedge funds. Registered FIIs can, however, sponsor other corporations as their 'sub-accounts' for investment into India. It is under this provision that most hedge funds currently invest into India.


Many global investors have identified India as a big opportunity for asset allocation. The Indian market is difficult to ignore, given its potential size, and sustainable growth rates over the long term. The volatility of the markets, provide a ready role for hedge funds in India. However, an investment in India is not for the weak hearted, and the ultimate winners will be those who can endure the ups and downs, and have the will to see the ride through to the end.

This article originally appeared in the AIMA Journal (Winter 2005 issue), published by the Alternative Investment Management Association.