Dollar shock for Indian hedge funds

2011 has been an annus horribilis for Indian hedge funds. All hedge funds, with one exception, are currently in the red — the Eurekahedge Indian Hedge Fund Index was down 16.9 pct as of end-October and early reports suggest that things went from bad to worse in November.

After witnessing two years of strong returns, Indian hedge funds started their 2011 campaign with two months of negative returns. It should be noted, however, that despite these losses, they managed to beat the market by significant margins.

For the first half of the year Indian hedge funds were able to hold their own in an adverse investment environment marked by high volatility and declining investor risk appetites. The average Indian hedge fund outperformed the market and by July-end 2011, the Eurekahedge Indian Hedge Fund Index was down only 5 pct while the market had declined by more than twice that much — the BSE Sensex was down 11.3 pct July year-to-date.

What came next proved to undo all the capital preservation that the managers had achieved — in August and September, Indian funds lost more than 14 pct on average due to sharp declines in the exchange rate of the rupee versus the dollar. As the Indian rupee depreciated 12 percent from 44 rupees per dollar to more than49 rupees per dollar, the NAVs (net asset value) of Indian hedge funds declined sharply.

In addition, market declines of 9.6 percent over the same period further exacerbated the situation.

To put things in perspective, most Indian hedge funds — more than 90 percent — have the dollar as their base currency, since they source the vast majority of their capital from overseas investors. As such, when hedge funds invest in the local Indian market, they face significant currency risk by converting dollars into rupees. However, their reporting is still done in the dollar, which means that by the end of each month, in addition to factoring in the returns from their investments, they also have to factor in the loss or gain posted by the rupee against the dollar during the month.

In the case of 2011, this was a loss of 12 percent in the two months of August and September. Early reports suggest a similar loss in November as the dollar breached the 52 rupee mark during the month.

Theoretically, hedge funds should be able to cancel out much of the currency exposure due to long positions in the market through their short positions; however Indian hedge fund managers are unable to do that as they take the short positions through the futures market, where they have to pay 20 percent of the value of their short exposure as margin, and since this is also in rupees it further adds to the currency risk. If a dollar denominated hedge fund, which invests in local currency, is 70 percent long and 30 percent short, the net exposure to foreign exchange risk would be 40 percent, because the 30 pct from short sale would be converted back to the reporting currency. However, in the case of Indian hedge funds, this exposure is actually 70 pct (long) plus another 6 pct (20 pct margin paid for the 30 pct short exposure).

In the second half of 2011, it was exactly this foreign exchange risk which has led to Indian hedge funds becoming the worst performers in the global hedge fund industry.

Such a sharp depreciation of the Indian rupee caught most managers by surprise. To make matters worse, the BSE Sensex fell 9.6 pct during these two months.

Although some managers, who had been bearish on market, were able to profit from the declining market, the currency return more than negated their gains. For instance, Heritage Capital India Fund, which had maintained a negative view on the market since January, saw its portfolio lose only 1/4th of the benchmark index (-20 percent YTD), but having the currency account for 2/3rd of its -14 percent YTD performance, because of the unexpected dollar appreciation, according to partner Jamshid Pandole.

In retrospect, it is easy to say that managers should have recognised their massive foreign exchange risk and taken measures to manage it. However, hedging foreign exchange risk would entail purchasing forward contracts, which would on average take 5 pct off the yearly bottom line, something that most managers are understandably not too keen to do. On the other hand, managers who are more focused on capital preservation and decided to take the additional protection of buying forward contracts after suffering losses in August-September, have largely escaped from the rupee depreciation in November (based on 20 percent of funds reporting).

Another way for Indian hedge funds to manage the exchange rate risk is to get their short exposure using equity index swaps (dollar denominated) rather than in the single stock futures market — and although this is a more cost-effective method than buying forwards, it is only applicable to the 20 percent margin exposure on the short side.

A number of managers believe that the Indian rupee has depreciated as much as it was going to, and going forward there is not much risk. Prominent amongst them is Samir Arora of Helios Capital Management, who believes that the Indian rupee should appreciate 3-5 percent in the next six months. Arora, who at one time managed more than USD 1 billion invested in India, says that if an investor still remains bearish on the currency, then it’s better for him to walk away from the market.

Amid the net declines seen in Indian hedge funds, there are still some positives. Calculating the market return on a dollar denominated basis shows that the Sensex returned -25 percent as of end-October 2011, while Indian hedge funds returned -17 percent, which can be considered an outperformance. In fact, a number of managers have reported flat to positive returns from the market, but a net loss due to the currency depreciation.

As we reach the end of the year, it will be interesting to see what investment themes worked for the successful managers during 2011 and what opportunities hedge fund managers foresee in the coming six months — watch this space.

Source:  ZeeNews

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