M.Com (Banking and Finance)Hedge Funds in Developing Countries

IntroductionA hedge fund is basically a fancy name for an investment partnership. It's the marriage of a fund manager, which can often be known as the general partner, and the investors in the hedge fund, sometimes known as the limited partners. The limited partners contribute the money and the general partner manages it according to the fund's strategy. A hedge fund's purpose is to maximize investor returns and eliminate risk, hence the word "hedge." If these objectives sound a lot like the objectives of mutual funds, they are, but that is basically where the similarities end.

The name "hedge fund" came into being because the aim of these vehicles was to make money regardless of whether the market climbed higher or declined. This was made possible because the managers could "hedge" themselves by going long or short stocks (shorting is a way to make money when a stock drops).

Key Characteristics

1. Only open to "accredited" or qualified investors: Investors in hedge funds have to meet certain net worth requirements to invest in them - net worth exceeding $1 million excluding their primary residence.2. Wider investment latitude: A hedge fund's investment universe is only limited by its mandate. A hedge fund can basically invest in anything - land, real estate, stocks, derivatives, currencies. Mutual funds, by contrast, have to basically stick to stocks or bonds.3. Often employ leverage: Hedge funds will often use borrowed money to amplify their returns. As we saw during the financial crisis of 2008, leverage can also wipe out hedge funds.4. Fee structure: Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee. The common fee structure is known as "Two and Twenty" - a 2% asset management fee and then a 20% cut of any gains generated.

There are more specific characteristics that define a hedge fund, but basically because they are private investment vehicles that only allow wealthy individuals to invest, hedge funds can pretty much do what they want as long as they disclose the strategy upfront to investors. This wide latitude may sound very risky, and at times it can be. Some of the most spectacular financial blow-ups have involved hedge funds. That said, this flexibility afforded to hedge funds has led to some of the most talented money managers producing some amazing long-term returns.

BREAKING DOWN 'Hedge Fund'Each hedge fund strategy is constructed to take advantage of certain identifiable market opportunities. Hedge funds use different investment strategies and thus are often classified according to investment style. There is substantial diversity in risk attributes and investment opportunities among styles, which reflects the flexibility of the hedge fund format. In general, this diversity benefits investors by increasing the range of choices among investment attributes.

Legally, hedge funds are most often set up as private investment limited partnerships that are open to a limited number of accredited investors and require a large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.

The first hedge fund was established in the late 1940s as a longshort hedged equity vehicle. More recently, institutional investors corporate and public pension funds, endowments and trusts, and bank trust departments have included hedge funds as one segment of a well-diversified portfolio.

It is important to note that "hedging" is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market. (Mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk." In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

A Hedge Fund at Work - A Fictional Example

To better understand hedge funds and why they have become so popular with both investors and money managers, let's set one up and watch it work for one year. I will call my hedge fund "Value Opportunities Fund, LLC." My operating agreement - the legal document that says how my fund works - states that I will receive 25% of any profits over 5% per year, and that I can invest in anything anywhere in the world.

Ten investors sign up, each putting in $10 million, so my fund starts with $100 million. Each investor fills out his investment agreement - similar to an account application form - and sends his check directly to my broker or to a fund administrator, who will record his or her investment on the books and then wire the funds to the broker. A fund administrator is an accounting firm that provides all the administration work for an investment fund. Value Opportunities Fund is now open, and I begin managing the money. Once I find attractive opportunities, I call my broker and tell him what to buy with the $100 million.A year goes by and my fund is up 40%, so it is now worth $140 million. Now, according to the fund's operating agreement, the first 5% belongs to the investors with anything above that being split 25% to me and 75% to my investors. So the capital gain of $40 million would first be reduced by $2 million, or 5% of $40 million, and that goes to the investors. That 5% is known as a hurdle rate, because you have to first achieve that 5% hurdle rate return before earning any performance compensation. The remaining $38 million is split 25% to me and 75% to my investors.

Based on my first-year performance and the terms of my fund, I have earned $9.5 million in compensation in a single year. The investors get the remaining $28.5 million along with the $2 million hurdle rate cut for a capital gain of $30.5 million. As you can see, the hedge fund business can be very lucrative. If I were managing $1 billion instead, my take would have been $95 million and my investors, $305 million. Of course, many hedge fund managers get vilified for earning such exuberant sums of money. But that's because those doing the finger pointing - often the newspapers - fail to mention that my investors made $305 million.

Hedge Fund StrategiesMany hedge fund styles exist; the following classification of hedge fund styles is a general overview.

Equity market neutral: These funds attempt to identify overvalued and undervalued equity securities while neutralizing the portfolios exposure to market risk by combining long and short positions. Portfolios are typically structured to be market, industry, sector, and dollar neutral, with a portfolio beta around zero. This is accomplished by holding long and short equity positions with roughly equal exposure to the related market or sector factors. Because many investors face constraints relative to shorting stocks, situations of overvaluation may be slower to correct than those of undervaluation. Because this style seeks an absolute return, the benchmark is typically the risk-free rate. (For more, see: Getting Positive Results With Market-Neutral Funds.)

Convertible arbitrage: These strategies attempt to exploit mis-pricings in corporate convertible securities, such as convertible bonds, warrants, and convertible preferred stock. Managers in this category buy or sell these securities and then hedge part or all of the associated risks. The simplest example is buying convertible bonds and hedging the equity component of the bonds risk by shorting the associated stock. In addition to collecting the coupon on the underlying convertible bond, convertible arbitrage strategies can make money if the expected volatility of the underlying asset increases due the embedded option, or if the price of the underlying asset increases rapidly. Depending on the hedge strategy, the strategy will also make money if the credit quality of the issuer improves. (See also: Convertible Bonds: An Introduction.)

Fixed-income arbitrage: These funds attempt to identify overvalued and undervalued fixed-income securities (bonds) primarily on the basis of expectations of changes in the term structure or the credit quality of various related issues or market sectors. Fixed-income portfolios are generally neutralized against directional market movements because the portfolios combine long and short positions, therefore the portfolio duration is close to zero.

Distressed securities: Portfolios of distressed securities are invested in both the debt and equity of companies that are in or near bankruptcy. Most investors are not prepared for the legal difficulties and negotiations with creditors and other claimants that are common with distressed companies. Traditional investors prefer to transfer those risks to others when a company is in danger of default. Furthermore, many investors are prevented from holding securities that are in default or at risk of default. Because of the relative illiquidity of distressed debt and equity, short sales are difficult, so most funds are long. (For more, see: Activist Hedge Funds: Follow The Trail To Profit and Why Hedge Funds Love Distressed Debt.)

Merger arbitrage: Merger arbitrage, also called deal arbitrage, seeks to capture the price spread between current market prices of corporate securities and their value upon successful completion of a takeover, merger, spin-off, or similar transaction involving more than one company. In merger arbitrage, the opportunity typically involves buying the stock of a target company after a merger announcement and shorting an appropriate amount of the acquiring companys stock. (See also: Trade Takeover Stocks With Merger Arbitrage.)

Hedged equity: Hedged equity strategies attempt to identify overvalued and undervalued equity securities. Portfolios are typically not structured to be market, industry, sector, and dollar neutral, and they may be highly concentrated. For example, the value of short positions may be only a fraction of the value of long positions and the portfolio may have a net long exposure to the equity market. Hedged equity is the largest of the various hedge fund strategies in terms of assets under management. It is also know as the long/short equity strategy.

Global macro: Global macro strategies primarily attempt to take advantage of systematic moves in major financial and non-financial markets through trading in currencies, futures, and option contracts, although they may also take major positions in traditional equity and bond markets. For the most part, they differ from traditional hedge fund strategies in that they concentrate on major market trends rather than on individual security opportunities. Many global macro managers use derivatives, such as futures and options, in their strategies. Managed futures are sometimes classified under global macro as a result.

Emerging markets: These funds focus on the emerging and less mature markets. Because short selling is not permitted in most emerging markets and because futures and options may not available, these funds tend to be long.

Fund of funds: A fund of funds (FOF) is a fund that invests in a number of underlying hedge funds. A typical FOF invests in 1030 hedge funds, and some FOFs are even more diversified. Although FOF investors can achieve diversification among hedge fund managers and strategies, they have to pay two layers of fees: one to the hedge fund manager, and the other to the manager of the FOF. FOF are typically more accessible to individual investors and are more liquid. (For more, see: Fund of Funds: High Society for the Little Guy.)

Hedge Funds Today

By most estimates, thousands of hedge funds are operating today, collectively managing over $1 trillion. Hedge funds can pursue a varying degree of strategies including macro, equity, relative value, distressed securities and activism. A macro hedge fund invests in stocks, bonds and currencies in hopes of profiting from changes in macroeconomic variables such as global interest rates and countries economic policies. An equity hedge fund may be global or country specific, investing in attractive stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices. A relative-value hedge fund takes advantage of price or spread inefficiencies. Other hedge fund strategies include aggressive growth, income, emerging markets, value and short selling.Another popular strategy is the "fund of funds" approach in which a hedge fund mixes and matches other hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk and volatility can be controlled by the mix of underlying strategies and funds.

New Regulations for Hedge Funds

One aspect that has set the hedge fund industry apart for so long is the fact that hedge funds face little money-management regulation. Compared to mutual funds, pension funds and other investment vehicles, hedge funds are the least regulated. That's because hedge funds are only allowed to take money from "qualified" investors - individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million excluding their primary residence. As such, the Securities and Exchange Commission deems qualified investors suitable enough to handle the potential risks that come from a wider investment mandate.

But make no mistake, hedge funds are regulated, and recently they are coming under the microscope more and more. Hedge funds are so big and powerful that the SEC is starting to pay closer attention. And breaches such as insider trading seem to be occurring much more frequently, an activity regulators come down hard on.

In September 2013, the hedge fund industry experienced one of the most significant regulatory changes to come along in years. In March 2012, the Jumpstart Our Business Startups Act (JOBS Act) was signed into law. The basic premise of the JOBS Act was to encourage funding of small businesses in the U.S by easing securities regulation. The JOBS Act also had a major impact on hedge funds: In September 2013, the ban on hedge fund advertising was lifted. In a 4-to-1 vote, the SEC approved a motion to allow hedge funds and other firms that create private offerings to advertise to whomever they want, but they can only accept investments from accredited investors. While hedge funds may not look like small businesses, because of their wide investment latitude they are often key suppliers of capital to startups and small businesses. Giving hedge funds the opportunity to solicit capital would in effect help the growth of small businesses by increasing the pool of available investment capital.

Hedge fund advertising deals with offering the fund's investment products to accredited investors or financial intermediaries through print, television and the internet. A hedge fund that wants to solicit (advertise to) investors must file a Form D with the SEC at least 15 days before it starts advertising. Because hedge fund advertising was strictly prohibited prior to lifting this ban, the SEC is very interested in how advertising is being used by private issuers, so it has made changes to Form D filings. Funds that make public solicitations will also need to file an amended Form D within 30 days of the offerings termination. Failure to follow these rules will likely result in a ban from creating additional securities for a year or more.

Not For EveryoneIt should be obvious that hedge funds offer some worthwhile benefits over traditional investment funds. Some notable benefits of hedge funds include: 1. Investment strategies that have the ability to generate positive returns in both rising and falling equity and bond markets. 2. Hedge funds in a balanced portfolio can reduce overall portfolio risk and volatility and increase returns. 3. A huge variety of hedge fund investment styles many uncorrelated with each other provide investors the ability to precisely customize investment strategy. 4. Access to some of the world's most talented investment managers. Of course, hedge funds are not without risk as well: 1. Concentrated investment strategy exposes hedge funds to potentially huge losses. 2. Hedge funds typically require investors to lock up money for a period of years. 3. Use of leverage, or borrowed money, can turn what would have been a minor loss into a significant loss.

Size of the Hedge Fund Market:

Since hedge funds do not register with SEC their actual data cannot be independently followed; therefore hedge fund data is self-reported. Despite the ambivalent image, hedge funds have attracted significant capital over the last decade, triggered by successful track records. The global hedge funds volume has increased from US $ 50 billion in 1988 to US $ 750 billion in 2003 yielding an astonishing cumulative average growth rate (CAGR) of 24 %. The global hedge fund volume accounts for about 1% of the combined global equity and bond market. The number of hedge funds increased from 1500 to about 8000 between 1998 and 2003. Estimates of new assets flowing into hedge funds exceed US $25 billion on average for the last few years. In the next five to ten years, hedge fund assets have been predicted to exceed US $ 1 trillion.In Europe the overall hedge fund volume is still small with about US $ 80 billion in 2003 which accounts for about 11% of the global hedge fund volume. The number of hedge funds in Europe is about 600. Within Europe, hedge funds become particularly popular in France and Switzerland where already 35% and 30% of all institutional investors have allocated funds into hedge funds. In 2003, Italys hedge fund industry nearly tripled in size as assets grew from Euro 2.2 billion to Euro 6.2 billion. Germany is at the lower end with only 7% of the institutional investors using hedge funds. But the Investment Modernization Act may well trigger rising interest from German investors. Overall, hedge fund assets are estimated to increase tenfold in Europe over the next 10 years. The acceptance of hedge funds seems to be growing throughout Europe, as investors have sought alternatives that are perceived as less risky during the last three years equity bear market.

This trend is also evident in Asia, where hedge funds are starting to take off. According to Asia Hedge magazine, some 150 hedge funds operate in Asia, till year 2002 which together managed assets estimated at around US $ 15 billion. In Japan, too hedge funds are becoming the focus of more attention. Recently, Japans Government Pension Fund one of the worlds largest pension fund with US $ 300 billion has announced plans to start allocating money to hedge funds. Industry participants believe that Asia could be the next region of growth for the hedge fund industry. The potential of Asian hedge funds is well supported by fundamentals. From an investment perspective, the volatility in the Asian markets in recent years has allowed long-short and other strategic players to outperform regional indices. The relative inefficiency of the regional markets also presents arbitrage opportunities from a demand stand point US and European investors are expected to turn to alternatives in Asia as capacity in their home markets diminish. Further, the improving economic climate in South East Asia should help foreign fund managers and investors to refocus their attention on the region. Overall, hedge funds look set to play a larger role in Asia.

Reasons for Rapid Growth of Hedge Fund Industry

While high net worth individuals remain the main source of capital, hedge funds are becoming more popular among institutional and retail investors. Funds of funds (hedge funds) and other hedge fund-Linked products are increasingly being marketed to the retail investors in some jurisdictions. There are a number of factors behind the rising demand for hedge funds. The unprecedented bull run in the US equity markets during the 1990s swelled investment portfolios this lead both fund managers and investors to become more keenly aware of the need for diversification. Hedge funds are seen as a natural hedge for controlling downside risk because they employ exotic investments strategies believed to generate returns that are uncorrelated to asset classes. Until recently, the bursting of the technology and telecommunications bubbles, the wave of scandals that hit corporate America and the uncertainties in the US economy have lead to a general decline in the stock markets worldwide. This in turn provided fresh impetus for hedge funds as investors searched for absolute returns.

The growing demand for hedge fund products has brought changes on the supply side of the market. The prospect of untold riches has spurred on many former fund managers and proprietary trades to strike out on their own and set up new hedge funds. With hedge funds entering the main stream and becoming respectable, an increasing number of banks, insurance companies, pension funds, are investing in them.

Market Benefits of Hedge Funds

Hedge funds can provide benefits to financial markets by contributing to market efficiency and enhance liquidity. Many hedge fund advisors take speculative trading positions on behalf of their managed hedge funds based extensive research about the true value or future value of a security. They may also use short term trading strategies to exploit perceived mis-pricings of securities. Because securities markets are dynamic, the result of such trading is that market prices of securities will move toward their true value. Trading on behalf of hedge funds can thus bring price information to the securities markets, which can translate into market price efficiency. Hedge funds also provide liquidity to the capital markets by participating in the market.

Hedge funds play an important role in a financial system where various risks are distributed across a variety of innovative financial instruments. They often assume risks by serving as ready counter parties to entities that wish to hedge risks. For example, hedge funds are buyers and sellers of certain derivatives, such as securitised financial instruments, that provide a mechanism for banks and other creditors to un -bundle the risks involved in real economic activity. By actively participating in the secondary market for these instruments, hedge funds can help such entities to reduce or manage their own risks because a portion of the financial risks are shifted to investors in the form of these tradable financial instruments. By reallocating financial risks, this market activity provides the added benefit of lowering the financing costs shouldered by other sectors of the economy. The absence of hedge funds from these markets could lead to fewer risk management choices and a higher cost of capital.

Hedge fund can also serve as an important risk management tool for investors by providing valuable portfolio diversification. Hedge fund strategies are typically designed to protect investment principal. Hedge funds frequently use investment instruments (e.g. derivatives) and techniques (e.g. short selling) to hedge against market risk and construct a conservative investment portfolio one designed to preserve wealth.

In addition, hedge funds investment performance can exhibit low correlation to that of traditional investments in the equity and fixed income markets. Institutional investors have used hedge funds to diversify their investments based on this historic low correlation with overall market activity.

From time to time, allegations are made by market participants about collusion among hedge funds to manipulate markets. Like all other market participants, hedge funds are covered by both criminal and civil regimes that outlaw various forms of market manipulation and abuse.

FINANCIAL CRISIS AND HEDGE FUNDSIn spite of difference of views, the role played by some of the large hedge funds has often been associated with major financial crisis that took place in the 90s.

East Asian Crisis

The impact of the East Asian crisis which materialized in the middle of 1997, and the subsequent turbulence that swept the worlds financial markets over the next 12 -18 months, has been significant not only in terms of the financial, economic and social consequences that these events wrought on emerging market economies, but also in terms of drawing the worlds attention to outstanding issues concerning the structure, operation and regulation of the international financial system.Causes of the crisis remain among the most contentious issues and continue to be debated at the academic as well as policy level. The Emerging Markets Committee of IOSCO identified multiple causes of the East Asian crisis. The Committee also made a reference to the role played by some hedge funds: complex trading strategies involving futures were thought by some authorities to have exerted a destabilizing influence on market performance in their jurisdictions. Currency speculators pursued a so - called double play aimed at playing off the Hong Kong currency board system against the administrations stock and futures markets. However, subsequent research could not produce robust evidence implicating the hedge funds for precipitating the crisis. Researchers have, however, attributed the negative public perception of the role of hedge fund managers in crisis partly to the limited information available about what they actually do.

Long Term Capital Management (LTCM)

Another major financial crisis involving a large hedge fund was that of the huge loss (US $ 4 billion) suffered by LTCM in 1998. LTCM built its positions on sophisticated arbitrage trading strategies. In addition, it used a significant degree of leverage to increase its expected return. In August, and September of 1998, as the global financial crisis worsened, it became clear to LTCM that many of the assumptions inherent in the arbitrage positions it held were incorrect. Due to LTCMs leverage (which at one point has exceeded 50 to 1), those incorrect assumptions resulted in substantial losses for the firm and eroded its capital base. Liquidation of LTCMs positions could have potentially disrupted the financial markets, resulting in losses for other participants in those markets. Finally, a consortium of banks worked out a rescue plan facilitated by the Federal Reserve Bank of New York, acknowledged that LTCMs potential impact on the worlds financial markets raises legitimate questions about the activities of hedge funds in general, as well as the proper role that regulators should play with respect to those activities. However, he also asserted that it was too soon to tell whether LTCMs investment strategies represent the norm in the hedge funds industry or, whether LTCM was an overly aggressive player among otherwise responsible market participants.

In response to the near collapse of Long -Term Capital Management, LP (LTCM), the Technical Committee of the IOSCO formed a special Task Force on Hedge Funds and Other Highly Leveraged Institutions to address regulatory issues relating to the activities of highly leveraged institutions (HLIs) or hedge funds. The Committee in its report underlined that HLIs, like other institutional investors, can provide benefits to global financial markets. It also highlighted the combination of characteristics typically associated with HLIs such as significant leverage, and the legal and other uncertainties arising out of the extensive operations in offshore centers posing particular challenges which need to be managed carefully in order to avoid risks to the financial system. The committee, as a defense against systemic risk in the market , recommended strong and prudent risk management processes at the regulated firms with which the HLIs trade. The Committee also highlighted the importance of transparent disclosure by the regulated entities dealing with HLIs and HLIs themselves on a voluntary basis, as a means to maintain market integrity.In spite of occasional negative perception about the role of hedge funds, such perceived misdemeanours by certain hedge funds have been considered more as occasional aberrations than general industry wide behaviour. This is also corroborated by the fact that many jurisdictions are gradually opening up their markets for hedge funds to establish and market their productsFurther, for the purpose of this paper it must be emphasized here that allowing access to offshore hedge funds to invest in India through FII route will not provide any opportunity to them to build up leveraged position onshore as borrowing by FIIs are not allowed under the terms of RBIs general permission.

COUNTRY EXPERIENCES

MALAYSIA

An example of the problematic effects of hedge funds was provided by the experience of Malaysia during the East Asian crisis (for a good summary of the debate on hedge funds role, see de Brower, 2001; for a more detailed analysis see Rodrik and Kaplan 2001). The Malaysian experience also provides a good example of how capital controls can - in certain circumstances - be effective in curbing speculative attacks and their negative effects.

Malaysia entered the Asian financial crisis with relatively strong fundamentals, and a much smaller share of short-term external debt in the total than neighbouring countries; short-term debt was also well below its foreign exchange reserves, which made it less prone to a run by foreign creditors.Nevertheless as a country with a very high level of indebtedness overall, it was quite vulnerable to turnarounds in general market sentiment that would be reflected in an increase in interest rates or reduction in credit availability. This was particularly serious in the context of intense contagion as the East Asian crisis spread.

In addition, Malaysia had the world's highest stock market capitalization ratio (310 percent of GDP). The rise in equity prices had in turn contributed to a domestic lending boom, leaving Malaysia in mid-1997 with a domestic debt-GDP ratio (170 percent) that was among the highest in the world (Perkins and Woo 2000,237).

Since June 1997 Malaysia experienced significant amounts of outflows. These outflows comprised mainly portfolio investments by non-residents in the Malaysian stock market. Consequently, stock prices declined by 65%, reducing the market capitalisation to a quarter of its prevailing levels prior to the crisis.Initially Malaysia also voluntarily took on IMF-type policies. But this did not work, as the high interest rates added to the corporate and banking crisis; the flexible exchange policy enabled the ringgit to depreciate; the freedom of capital mobility allowed funds to flow out; and the cutbacks in government expenditure added to recessionary pressures.

At the end of June, 1998, alternative policies were formulated. They attempted to reflate the economy through cuts in interest rates and credit expansion, but the attempt to reduce domestic interest rates was undercut by growing speculation against the ringgit in offshore markets.

Those offshore centres provided easy access to ringgit funds for speculative activities. At its peak, offshore ringgit deposits were attracting interest rates in excess of 30%. Such high interest rates demonstrated just how profitable ringgit speculation had become. It also revealed the constraints imposed by external developments on the conduct of monetary policy. Offshore institutions (mainly in Singapore) borrowed ringgit at premium rates to purchase dollars and bet in favour of the ringgit's collapse. The economy's decline continued.

The controls that were established by Malaysias economic authorities in September were aimed at finishing this speculation. They were the following:

To shut down offshore trading, the government mandated that all sales of ringgit assets had to go through authorized domestic intermediaries, effectively making offshore trading illegal.

All ringgit assets held abroad had to be repatriated. Worried that these measures would lead to an outflow of capital and further depreciation of the currency, the Malaysian government also banned for a period of one year all repatriation of investment held by foreigners.

Simultaneously, in an attempt to revive aggregate demand, Malaysia lowered the 3-month Bank Negara Intervention Rate from 9.5% to 8%. On February 15th 1999, the Central Bank of Malaysia changed the regulations on capital restrictions, shifting from an outright ban to a graduated levy and replacing the levy on capital with a profits levy on future inflows.

In order to not affect FDI or current account transactions, repatriation of profits and dividends from (documented) FDI activities were freely allowed. Foreign currency transactions for current-account purposes (including the provision of up to 6 months of trade credit for foreigners buying Malaysian goods) were also not restricted.

The ringgit was fixed to 3.8 to the US$.

Regarding the advantages of this policy Rodrik and Kaplan, op cit rightly argue that the results of Malaysian controls have to be evaluated from two different perspectives - financial and economic; from the financial viewpoint, a significant question was whether the financial segmentation was put to good use? On this aspect, it is important to highlight that the government had no difficulty in sharply lowering domestic interest rates, and making the fixed exchange rate stick without the appearance of a black-market premium for foreign currency. As an IMF paper states, "there [were] only a few reports of efforts to evade controls, and no indications of circumvention through under invoicing or over invoicing of imports (Kochhar 1999, p. 8). Another IMF staff report concludes that the controls were effective in eliminating the offshore ringgit market and choking off speculative activity, including that by hedge funds against the ringgit despite the easing of monetary and fiscal policies (Ariyoshi et al. 1999). More systematic, comparative evidence is presented by Kaminsky and Schmukler (2000) and Edison and Reinhart (1999). These papers finds that the September 1998 controls were successful in lowering interest rates, stabilizing the exchange rate, and reducing the co-movement of Malaysian overnight interest rates with regional interest rates.

Furthermore, as Stiglitz (1999) argues, the Malaysian experience showed that one can intervene in short-term flows, and still provide a hospitable environment for foreign direct investment.

Indeed, there is now consensus that though fairly drastic, the Malaysian capital controls did not deter future FDI, and that they contributed to curb potentially very disruptive speculation by actors, such as hedge funds. From a broader economic aspect, they were one of several factors that contributed to fairly rapid recovery of the Malaysian economy.

HONG KONG

In the summer of 2008, East Asia was in the midst of a major crisis and Hong Kong had a recession. There were concerns among investors about the Hong Kong stock market, which had been falling rapidly, and doubts about the survival of the Hong Kong currency peg, in spite of the commitment by the authorities to maintain the currency board (see Goodhart and Dai, 2003, for an excellent discussion of the background, speculative attack and intervention).

Several factors made Hong Kongs currency vulnerable to speculative attack. These included: the commitment to a fixed exchange rate, the initial small size of the monetary base, the unrestricted ease of short-selling, in stock spot and index futures markets, and the laxity in the enforcement of settlement. To this was added the ease with which speculators could borrow Hong Kong dollars, either in the interbank market or via swaps with multilateral institutions that had issued a large volume of Hong Kong dollar debt.

Indeed, the hedge funds reportedly launched their attack on Hong Kong after careful planning. The hedge funds had pre-funded themselves by borrowing and sitting on large amounts of Hong Kong dollars. From the beginning of 1997 to the middle of August 1998, over HK$30 billion of one and two-year money was raised through the issue of debt paper in Hong Kong. According to Yam (1999) this pre-funding by hedge funds insulated them from the sharp increase in the HK dollar interest rates when the short-selling of HK dollars began.

In this context, a few large hedge funds (HFs) moved to attack both the currency and the stock market. In the view of the Hong Kong authorities, the double play proceeded as follows. First, HFs shorted the Hong Kong (spot) stock market as well as the Hang Seng Index futures. Next, by using forward purchases of US dollars and spot sales of Hong Kong dollars, they tried to induce a devaluation. Apparently, the size of the short positions of these HFs in the forex and stock markets were very large. Indeed, the Hong Kong government estimated that speculators sold short Hong Kong stocks for US$6 billion in the first two weeks of August (NBER). On 14th August 1998, the HKMA entered the equity market, drawing on official reserves to purchase stocks with the aim of ensuring that the speculators (who were mainly hedge funds) did not profit from their short positions. Prior to the intervention the stock market had fallen by 40% from 1st May 1998 to 13th August 1998. As a result of the intervention the stock market was successfully pushed up. The government stock purchases lasted ten working days. As disclosed by the government the HKMA spent HK $118 billion overall in the process of acquiring shares, representing about 7.3% of such stocks.

Indeed the Double Market Play of hedge funds implied the following: (Goodhart and Li, op cit). The speculators simultaneously sold short Hong Kong dollars, both spot and forward, on the foreign exchange market and shorted Hong Kong stocks on both the spot and futures markets. Such massive selling of Hong Kong dollars squeezed the liquidity of the Hong Kong banking system, leading to a sharp increase in interest rates. The stock and futures markets were then under great pressure to fall. Moreover, if under such pressures the HKMA were to give up the Hong Kong dollar peg, the speculators could reap enormous profits from the foreign exchange and, potentially, also the securities markets. The Hong Kong residents, on the other hand, would have to suffer the collapse of their asset markets, and with banks facing serious difficulties, there was a risk of a banking crisis, like what had happened in other Asian countries.

As a result of this massive intervention by the authorities in the stock markets, the HK peg was maintained. Furthermore, the risk premium on the HK$ fell from a high of 1250 basis points in August to 45 basis points in December 1998, comparable to the pre-crisis level. The speculators were defeated. Furthermore, the HKMA actually made a large profit from its intervention when they sold the shares later at higher prices.

The Hong Kong experience is unique for several reasons. Firstly, though risky at the time, it provides a fairly rare example of a very successful government intervention against large speculation by hedge funds. Secondly, it was carried out by a government deeply committed to free markets. Thirdly, the intervention was done through the stock market, which is also quite rate.From the perspective of this study, it is important to stress the following points. One of the crucial pre-conditions of the successful intervention in Hong Kong was the availability of large foreign exchange reserves; a second pre-condition was quite detailed knowledge by the economic authorities of what the hedge funds were doing. This emphasizes the importance of transparency of information, and its availability to authorities.

Finally, as Goodhart and Li stress the intervention was worthwhile, as the HK economy with intervention was in a far better condition than it would have been without the intervention. Nevertheless, it seems better to try to prevent such speculative attacks as the risks and potential costs of intervention can be very large. (See below discussion of Brazilian experience)

The HK Government later created a vehicle to divest the acquired shares, the Tracker Fund of Hong Kong, which was listed in 1999. As mentioned, the Government sold the shares at a large profit.

It is interesting to stress that in addition the government brought in a 30-Point package tightening the regulation of the securities and futures markets, including of course aspects relating to hedge funds. They introduced measures covering short selling, system improvement, risk management, and intermarket surveillance.

The Government introduced a major three-pronged market reform in March 1999.The three prongs were the modernisation of the securities legislation, demutualisation and listing of the stock and futures exchanges, and the enhancement of financial infrastructure

Some of the measures in the package include the strict enforcement of the settlement process, imposing a super margin on brokers with highly concentrated positions, introducing the client identity rule, increasing the penalty for naked short selling, creating a new offence for unreported short sales, and introducing new requirements for stock lenders to keep proper records of their lending activities.

In parallel, the stock market re-introduced the up-tick rule (no short selling below the current best ask price) for covered short selling and HKFE tightened the large open position reporting requirements and imposed position limits for HSI Futures and Options Contracts.

In the period 1999-2003 further modernisation of the regulatory regime and market facilitation took place.

The most significant regulatory development was the enactment of the Securities and Futures Ordinance. Some of the key features were the following:(a) a new dual filing arrangement that ensures timely and accurate disclosure of information by listed companies and listing applicants. False or misleading disclosure made knowingly or recklessly is liable to prosecution; (b) insider dealing, market manipulation, dissemination of false and misleading information can be pursued either by prosecution or through a new Market Misconduct Tribunal. The Tribunal may impose a range of deterrent sanctions; (c) a single licensing system that brings improved cost effectiveness to licensed market practitioners; (d) the SFC has greater flexibility in determining disciplinary sanctions against licensed practitioners misconduct.

The SFC is now considering relaxation of the regulations relating to short selling and derivatives activity. Relaxation measures applicable to certain market neutral transactions have been introduced. The short selling exemption is expected to enhance the liquidity of both the cash and futures markets.

Furthermore Hong Kong is reportedly poised to relax an important licensing requirement for international hedge fund managers in a move that could help the territory fend off competitive challenges from Singapore and other lightly regulated financial centres.

The move could allow a hedge fund manager to become a responsible officer without taking the regulatory exam. Analysts said the change should help streamline a licensing process that can take 18-20 weeks. Reportedly, however, Hong Kong has so far ruled out following Singapore, where hedge funds can set up shop in less than a week.

It may be a cause of concern that HK, having been so threatened by major disruptions to its economy caused by hedge funds and derivatives is now considering relaxing its regulations, reportedly due to competitive pressures.

BRAZILBrazil had a rather different experience, especially as compared with Hong Kong. In the wake of the Asian crisis, during 1998 and 1999, there emerged speculative pressures on the Brazilian real. These were partly caused by a somewhat overvalued exchange rate and a fairly important fiscal deficit.However, a big role was played by contagion from the Asian and Russian crisis, as well as LTCM, and the actions of financial actors, including HLIs. One of the main mechanisms for this contagion was through the Brady bonds (Franco, 2000; Dodd and Griffith-Jones, forthcoming). Indeed, hedging strategies for long positions in Russian instruments had been constructed against a short position of the EMBI, (the Emerging Market Bond Index), in which Brazilian paper was very important or against Brazilian paper, which was the most liquid in the market. Franco, op cit argues that there was no question that the way the short selling was done was meant to drive the price of the Brazilian bonds downwards, to reduce losses in Russia. It has been reported (interview material) that a number of dubious practices were used by market actors, including HLIs, such as short selling a larger amount of bonds that were available in the market. According to Franco, op cit, (then Governor of the Brazilian Central Bank), these transactions carried out offshore violated International Securities Market Association rules, to which trading houses subscribe on a voluntary basis .Reportedly a challenge to these practices by Brazilian banks produced threats of retaliation on the part of the market makers. This implied a regulatory asymmetry that did not allow Brazilian banks to challenge short sales that were detrimental to market integrity

More generally, pressure on the real was exerted both on the spot and the large foreign exchange derivatives markets by a number of actors including HLIs. The Central Bank tried to resist this pressure and defended the exchange rate by intervention in both the spot, and especially, the derivatives market. The justification for the latter was that in this way the Central Bank would have a better chance to defeat the speculators, that were highly leveraged. Though the Central Bank was successful in 1997, by 1998 the level of pressure had increased, and by early 1999 the Brazilian authorities were forced to abandon their exchange rate regime and float, as capital outflows became massive and there were large short positions against the Brazilian real in the derivatives markets. The intervention was costly for the Central Bank, and eventually not successful. However, the fact that the Central Bank had intervened in the derivatives market provided hedges for corporates and banks, which helped soften somewhat the impact of the devaluation on the real economy. Unlike in East Asia, GDP did not fall during the year of the crisis, 1999, though growth was very anaemic for several years, as a result largely of the crisis.

It can be concluded that the Brazilian experience was more problematic than that of Hong Kong. This may have many reasons, but the fact that Brazil had a relatively lower level of foreign exchange reserves, by the end of 1998, may have been an important factor.

Further research seems necessary to understand what determines whether intervention by economic authorities is successful or not in their defence against speculative pressures, by HLIs as well as by other market actors, in different circumstances and countries.

Finally, it is important to note that since 2003, there has been a tendency for excessive appreciation of the Brazilian real. This was partly determined by fundamentals, such as an increasing current account surplus. However, there is strong evidence, that part of the appreciation is due to carry trade between the high interest Brazilian real and low interest currencies like the yen or the Chilean peso, carried out to an important extent by HLIs. (See UNCTAD, 2007). Again efforts of the Central Bank, this time to resist appreciation, has not been very successful.

THE SUBPRIME CRISIS AND ITS EFFECTS ON EMERGING MARKETSThe subprime crisisFinancial markets have been experiencing important transformations during the last decade through the emergence of new innovations (hedge funds and private equity ) and new instruments (derivatives and structured products).

Regarding hedge funds, it is worth mentioning Quants. These make their decisions based on sophisticated computerized models. Because of their high returns (over the last twenty years Renaissance Technologies flagship fund had an average annual return of 30 percent ) Quants grew very rapidily and now they are thought to represent about one quarter of all US equity hedge funds.

Among the new instruments, innovations have included financial instruments for securitising debt into assets. Many of these debts were high-risk loans made to home buyers with poor credit or little income the so-called subprime borrowers. Such loans do not conform to the criteria for prime mortgages, and so have a lower expected probability of full repayment.

In order to make these assets more appealing to risk averse investors like banks, the asset structurers have been combining them with supposedly safer loans instruments called collateralised debt obligations (CDOs). Those CDOs, in the absence of a liquid market in papers, were valued on the basis of models and ratings, mainly AAA ratings.

Many of the subprime loans had introductory teaser rates that reset after two or three years. With the US economy slowing, interest rates rising and house prices falling, subprime mortgage defaults climbed. As this market was hit hard, those securities were repriced downward. This, in turn, infected the CDOs because following the losses on the underlying subprime mortgages nobody any longer trusted either the models or the ratings. (See EIU,2007)After some investment managers realized losses in the subprime mortgage markets, investment banks asked hedge funds to reduce their leverage. In order to obtain the necessary cash, hedge funds had to sell assets, but since mortgage-linked CDOs are not liquid, they decided to sell liquid high-quality equities. As the prices of quality liquid assets started falling other Quants funds - which in a crunch scenario were programmed to go long on this type of assets and short on illiquid high beta stocks - started making losses as market prices were not confirming their assumptions. Hence the margin calls and the need to sell high quality assets forced the market to do exactly the opposite of what models predicted. Losses were amplified by their initial leverage and by the fact that most Quants worked with similar models. Goldman Sachs annouced that its Quants hedge funds lost approximately 30 percent of their value in a week. In its letter to investors the company announced that the losses were due to a 25 standard deviation event. The probability of a 25 standard deviation event can happen with a 5% probability and such an occurrence should happen once every 100,000 years. The problem is that these black swans seem to be happening more often than they should. It was such an event that caused the LTCM collapse in 1998. Goldman Sachs injected US$ 4 billion into its global equity fund and external investors injected US$ 1 billion. Another of the main hedge funds to suffer were a couple run by the investment bank Bear Stearns. One of these funds invested in cash and derivative instruments tied to CDOs backed by subprime residential mortgages. As this market was hit hard those securities were repriced downward. To increase returns the Bear Stearns fund had high leverage. This added to declining security values as it meant margin calls by the Wall Street investment banks that did the lending. When one bank, Merrill Lynch, found it difficult to find buyers for their loans collateral the result was severe downward pressure on those and similar CDOs tranches. In addition other hedge funds faced margin calls from lenders forcing them to sell good assets to raise cash. Sometimes certain funds had to implement other measures. BNP for example froze withdrawals by investors in three of its hedge funds. All of this was occurring parallel to corporate borrowing costs soaring, mergers and acquisitions drying up, and stock prices falling. Most seriously, the biggest institutions became reluctant to lend to each other in the interbank market since it was difficult for lenders to assess other financial institutions exposure to subprime losses.As a consequence the supply of funds in money markets was squeezed restricting the supply of short-term financing for financial institutions and threatening a systemic liquidity crisis.Several German, UK, US, and Chinese banks were affected linked to the repricing of risky assets and deleveraging by investors. The UK suffered the first bank run in almost 150 years. Though this was mainly caused by the inappropiate business model of Northern Rock, as well as regulatory failures, reportedly hedge funds played a role in accentuating the problem, by shorting the banks shares, which they had borrowed from institutional investors. According to some estimates, at one point, as much as 50% of Northern Rock shares were being shorted by HLIs; the resulting declines in the price of shares contributed to increasing panic, untill the Bank of England provided its lender of last resort facility.

Monetary policy has played a key role in determining the consequences of the crisis. Central banks liquidity injections were followed by interest rate cuts. The first intervention was by ECB followed by central banks in the US, Japan, Australia, and Canada that injected funds into their economies to keep them functioning. Also on the 18th September the US Federal Reserve cut its target rate for the first time in three years from 5.25% to 4.75%.s

As investors and financial institutions reappraise the risks associated with different assets, prices of all sorts of instruments - equities, corporate and government bonds, commodities - have been adjusted to new and generally lower levels. For any given level of risk, financing is likely to be more expensive.

The effects in emerging marketsi. According to the IMF (2007), emerging market risk had broadly declined in recent years, supported by the then benign global economic outlook, improved macroeconomic performance, improving sovereign debt profiles, and commodity prices. External positions generally remain very strong, and robust growth led to an improvement in fiscal positions in many countries.

The concern about the consequences of the subprime crisis on EMs can be explained in terms of risk models. These models determine that certain funds, including HFs, which orient their investment in certain countries financial instruments, take decisions that affect those instruments themselves. This decision - from the point of view of an individual fund - is a rational response to a particular expectation. However, this situation when undertaken by various funds could lead to systemic risks.

Also there are several vulnerable points where EMs can be affected by additional volatility in mature markets. These weaknesses are related to the growing market of privately placed syndicated loans in emerging markets that share similar evidence of credit indiscipline as in the leveraged loan segment; emerging market banks in some regions are relying increasingly on international borrowing to finance rapid domestic credit growth; emerging market corporates appear increasingly engaged in the carry trade; and some emerging market financial institutions in several countries are increasingly using structured and synthetic instruments to increase returns, potentially exposing them to losses as volatility rises. Many of these points, as we will see later, are related to the HF investment strategies.ii. As a product of this recent turmoil and the associated reappraisal of risk, new issues from emerging markets increased in price. Nevertheless, the increase in spreads has so far been relatively moderate for most developing countries.iii. Another consequence of the subprime crisis can be seen through the greater difficulties for launching new issues in international markets. During the recent credit squeeze international markets were closed to new issues and reopened only after the US Federal Reserve cut interest rates. A number of sovereign borrowers used that thaw to come to market, including Mexico and Ghana which made its international debut with a $750 million 10-year offering. Nevertheless, the answer to this question is not unique. Some EM countries have reduced their need for funds because of record-high commodity prices, increases in manufactured exports and rising forex reserves. Others, however, did not: Europe and Central Asia now absorb nearly half of all international bank and bond financing. These economies are, accordingly, vulnerable to shifts in external credit.iv. A fourth consequence is related to the impact of the crisis on the US economy. Regarding this, global growth will be slower in the next quarters and this will negatively influence the economy of most developing countries, unless the rest of the world compensates for slower US growth.

HEDGE FUNDS IN INDIAIndia focused hedge funds have posted spectacular returns in 2014 against the backdrop of rising domestic equity markets, and a renewed sense of confidence in the Indian economy which is being led by Narendra Modi. Hedge funds investing with an Indian mandate have topped the performance tables in 2014 and in this special section of The Eurekahedge Report, we ask some of the top performing Indian hedge fund managers about their winning themes during the year, in addition to investor allocation activity and the key macroeconomic themes which they will be watching out for in 2015.

In 2014, the average Indian hedge fund was up 39.36%, outperforming underlying markets by almost 10%. Managers running long/short equity strategies emerged as the clear winner posting gains of 54.83% -their best performance in the last eight years. Figure 1 below details the historical performance of Indian managers relative to the BSE Sensex Index and shows how managers focused on the country have rebounded after a relative lull over the preceding four years.

In terms of asset growth, Indian hedge fund assets under management (AUM) are currently at a seven year high of US$3.45 billion, though roughly 36% below their 2007 peak of US$5.36 billion. The average Indian hedge fund was down 50.66% during the 2008 financial crisis, witnessing steep performance - based losses and investor redemptions from which the Indian hedge fund industry is yet to recover.

Since 2009, Indian managers have posted an eight year annualised return of 10.89%, and barring 2011, their AUM continues to trend upwards albeit at slower pace compared to the broader Asian hedge fund space. Managers have raked in roughly US$700 million in performance - based gains in 2014 while seeing net inflows of US$215 million during the year. While investor flows have not kept pace with manager performance in 2014, going forward one should expect an uptick in investor allocation towards India as the country remains a much better value proposition for investors compared to some of its emerging market peers and a clear beneficiary of the lower oil prices. Structural weaknesses within the economy and the risk of capital flight following a rise in US rates could potentially upset the prospects of the Indian markets in 2015.

CONCLUSION Hedge Funds as a whole are becoming a prominent segment of the asset management industry and gaining popularity from investors particularly from high net worth investors, universities, charitable funds, endowments, pension funds, insurance and other institutional investors. Most hedge fund managers are embracing the new sources of capital from institutional investors, who are, by their very nature, highly regulated and their investments scrutinized. They encourage the hedge funds to improve their internal controls to meet the Alpha requirements.

The assets under management of the hedge funds are growing on a double digit rate and it is estimated that worldwide the Hedge Fund industry is nearly $3 trillion dollars. This has created a lot of disquietude for financial regulators as Hedge funds are able to influence markets in a more radical manner than they would do so when they first started.

In India the issues are intended to widen the FII inflow and to allow these alternatives investment pools to our securities market in a transparent and orderly manner. In addition, the suggestions also provide for adequate safety measures to address legitimate concerns associated with these funds. Most industry people are of the view that regulation is welcome and good but only if it does not impinge on innovation, competitiveness and the industry's ability to evolve. It's all about educating the investors and ensuring they know what they are getting into.

Hedge Funds bring liquidity to capital markets, and also make capital markets more efficient because they scour the financial landscape for inefficiencies, and then use expertise to structure the optimal investment to take advantage of the opportunity. They have been instrumental in transforming the investment landscape, making it much broader than equities, bonds and property. Hedge funds have acted as a beachhead in new investment strategies, including middle market lending, asset- backed lending, credit derivatives, reinsurance, and carbon credits.The greater challenge for the regulators is as to how to increase compliance and protect investors without making hedge fund managers relocate to unregulated jurisdictions.

REFERENCES Alternative Investment Management Association (2002), Guide to Sound Practices for European Hedge Fund Managers, August.

Alternative Investment Management Association (2007), Guide to Sound Practices for European Hedge Fund Managers, May.

An overview of the Major Events and Regulations of The Securities and Futures Markets Between 1997 and 2007,Securities and Futures Commission, June 2007.

WEBLINKS (Hedge Funds in India)http://www.hedgefund-index.com/Legal%20Framework%20for%20Hedge%20Fund%20Regulation.pdf (Hedge Funds Definition)http://www.sebi.gov.in/cms/sebi_data/attachdocs/1293006463914.pdf[18]