The Hindu Business Line : `Hedge fund managers often help prevent market risks'

In reality, hedge funds provide insurance against market shocks by providing price discovery and liquidity. — MR JOHN G. GAINE, PRESIDENT, MANAGED FUNDS ASSOCIATION, US

We have come a long way from the time when the word "hedge fund" sent a chill down the spines of market participants. Though sporadic incidents such as that involving Long Term Capital Management and Amaranth do highlight the risks associated with them, investor losses in hedge funds in a year are less than a third of a per cent. The mysterious aura surrounding these instruments can be partly attributed to the complex and sophisticated strategies hedge fund managers use. With over $1.7 trillion in assets under management and a significant portion being leveraged, the influence that hedge funds wield over global equitiesis undeniable.

The MFA (Managed Funds Association), headquartered in Washington D.C. is the only US-based global membership organisation dedicated to enhancing the understanding of the hedge fund industry, fostering dialogue with regulatory authorities and otherwise improving communication about the alternative investment sector. The MFA's membership numbers over 1,300 professional managers, who collectively manage over $530 billion in assets.

Mr John G. Gaine, President of the MFA, was recently in India for the Annual Conference of the International Organisation of Securities Commissions (IOSCO). He answered Business Line's queries on the road ahead for the hedge fund industry, the misconceptions surrounding it and India as a potential market for these funds.

Excerpts from the interview:

The rapid growth and increasing popularity of hedge funds as an alternative source of investment, is known to us all. What, according to you, is the principal factor that draws investors to hedge funds?

Institutional and wealthy investors are drawn to hedge fund strategies as a risk management tool. They invest in alternative strategies to complement their long-only investments and create a diversified portfolio that has the potential to generate improved performance while reducing volatility. When combined with traditional investments, alternative strategies may provide powerful risk-adjusted returns to the portfolio at large. Both academically and pragmatically, this is a very compelling investment strategy.

How do you see this industry shaping up over the next ten years? Do you see the gap between the hedge fund industry and the mutual fund industry (in terms of the assets under management) narrowing?

Investments in hedge funds and other alternative investment strategies will continue to grow over the next ten years for many reasons, not the least of which is to gain diversification. As more assets flow into alternative strategies, the asset gap will continue to narrow.

Whenever a stock market in any emerging country crashes, the finger is inevitably and rather senselessly, pointed at hedge funds. How do you counter such assertions?

I explain that in reality hedge funds provide insurance against market shocks by providing price discovery and liquidity. Fund managers are generally very sophisticated risk managers and, consequently, they are far less likely to cause a market shock or overreact when one occurs. In fact, hedge fund managers more often than not are actively preventing markets risks from developing in the first place, something that is generally overlooked.

Is retailisation here to stay or will the industry revert to being the preserve of the `sophisticated' investors?

In the US retailisation is not an issue. The MFA has testified that it supports the move by the US Securities and Exchange Commission to limit access to private placement of hedge fund interest to individuals of sophistication and high net worth.

Our US approach is to balance investor protection and investment freedom. Such a The balance struck limits the investor base of those funds able to exercise total investment freedom, subject to anti-fraud and manipulations provisions, of course.

Access to funds with the unlimited capacity to develop trading strategies is limited to those investors who can understand fully the types of trade-offs and risks that they are undertaking and have the financial wherewithal to withstand them.

The MFA sees no need to move the fulcrum closer to making these types of investments available to retail investors or to alter regulation to anticipate that eventuality. This is true even though some commentators on the SEC proposal are clamouring for access to hedge fund-type returns.

We believe that the balance being set within the US has fostered investor protection, advanced market discipline against systemic risk, and been consistent with the policies of disclosure as opposed to merit-based regulation. We believe that now is not the time to upset this balance.

What are the factors an investor should weigh before selecting a hedge fund for investing?

Extensive due diligence should be the hallmark of a hedge fund investor. Investors need to understand the investment objective and the strategy in which they are looking to invest, and they need to carefully analyse how it will correlate with their other investments.

There are very sophisticated analytical tools in the marketplace today that allow you to construct virtual portfolios and assist in doing due diligence on managers.

The MFA's Sound Practices is a guide we developed for hedge fund managers on creating best practices that is also a useful tool for investors because it sets standards of excellence in a wide range of categories. Investors can use it as a checklist when selecting managers with whom to invest.

What is the key challenge before the MFA? Our principal challenge is providing information to and educating policy-makers and the media around the world. The industry is still relatively new and not well understood. The MFA has made enormous progress, but it will take time to correct the misperceptions that have been created in recent years. The MFA's focus, as it has been the past and will be in the future, in on protecting and promoting the benefits that alternative strategies bring to bear on the global capital markets and the value they can add to an investment portfolio.

What has been the MFA's experience in dealing with stock market regulators in various countries? Are you satisfied with the pace of acceptance of this form of investment?

Regulators around the world share the MFA's desire for hedge fund policy that provides appropriate safeguards for investors and their country's economy. The pace of understanding has been good and, in our opinion, will only get better.

How does the hedge fund industry view the long-term growth prospects of Indian equities?

The industry is excited about the growth prospects of investing in India and sees mutual benefits for India's listed companies and for the portfolio managers who are investing in India.

How has your interaction with the Indian regulatory authorities been?

On my recent trip to India, I had extremely productive meetings with the Indian Ministry of Finance and SEBI and, in particular, with its Chairman, Mr Damodaran, and I feel that you will see accelerated investment by hedge funds in India.

In your opinion, how many years would it take before hedge funds come forward to raise money from Indian investors?

It is not a matter of years at all. Cultivating investors may be happening already.

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