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
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
Figure 3: Plan Figures for
Source: Plan Documents and CRIS
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
Source: Kotak Institutional Equities,
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
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
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
Figure 5: Daily Average Turnover - Derivatives
Segment (September 2005)
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 (subUS$100 million) can
also use options quite effectively in range
- 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.