‘Regulation of hedge funds defeats their purpose’

He may be used to the vagaries of the markets he invests in, but on Friday, Dr Carlos Asilis got a taste of the unpredictability of Mumbai’s rains. But this chief investment officer of the Linnaes Fund, a global macro hedge fund of New York-based Vega Plus Asset Management, was unfazed as he braved the torrential downpour to make it well in time for his rendezvous with Sanat Vallikappen. He was in Mumbai as advisor to Glovista Investments, a US-based investment firm that has just started offering portfolio management services in the country. Glovista has also applied for a foreign institutional investor status in India. With the Securities and Exchange Board of India chairman M Damodaran saying that the case for regulating or not regulating hedge funds lies somewhere in between, we came directly to the point.

Being the manager of a hedge fund, what is your view on this contentious and much-debated issue?

A hedge fund is a good concept as it enhances market efficiency and leads to better resource allocation in a market-based economy.

But like everything in life, hedge funds can also be misused and may distort prices and market dynamics. In that sense, it is essential to regulate them.

But on the other hand, the very purpose of what a hedge fund does - make maximum returns at all times - would be beaten if they are regulated.

They have a wide breadth of instruments to choose from, and the flexibility and speed at which they can change their calls along with the dynamics of the market, sets them apart from ordinary mutual funds. So if they are regulated, these functions will be impinged upon.

What do you mean by better resource allocation?

I can give you some examples. Two years ago, the market capitalisation of some bank stocks in some Middle Eastern countries was higher than that of Goldman Sachs, the largest securities firm in the world (in terms of market cap). Similarly, in the early 1990s,

Mexico’s largest bank Banamex was higher in market cap than JP Morgan, America’s third-largest bank in market cap.

These happened because the local financial economy in these countries was in disequilibrium and there was no way people could go short on these stocks. If hedge funds were allowed here, and allowed to go short, this mispricing would not have happened.

But more often than not, hedge funds are blamed for driving up valuations?

Hedge funds themselves are not known to initiate new trends. But theoretically, when they get on to a bandwagon, they can drive up valuations. But if valuations go out of whack, then other hedge funds step in to correct the mispricing.

Of course, this can happen only in a market where securities are allowed to be short-sold, or there is a developed derivatives market. A hedge fund is a vehicle that can correct such disequilibria.

So does India need to regulate hedge funds?

I don’t think so, because India exhibits a very high level of financial development, the banking supervision is very strong, and there is much transparency of information.

Hedge funds could be destabilising in smaller countries, let’s say in some countries in Africa, Latin America and Eastern Europe —  these are relatively small markets where regulations governing the capital market are not that robust.

But when we hear of so many investors losing money in hedge funds that have gone bust (Amaranth, Baer Stearns, etc) isn’t there a case for regulating them?

How to protect investors in hedge funds is an entirely different issue. It’s true that many hedge funds have a contractual agreement with their clients.

These agreements talk about where the hedge fund is going to invest, but very often, it turns out that it invests in entirely different assets. This is in violation of the spirit of the agreement. But again, here it’s not just hedge funds alone that need to be blamed. I believe that the Baer Stearns funds that went bust had a part of the retirement funds of policemen and firemen.

If the investment officers managing these funds put part of this into hedge funds, they also need to take some blame. They should understand that hedge funds are highly leveraged. I cannot pretend to tell you what the correct answer is.

There should definitely be greater guidelines on investor protection, but where one should draw the line, is still an open debate.