ALTERNATIVE INVESTMENT

Important Concepts of Alternative Investment :

The fundamental concept of Alternative Investment is that this is the market
where the funds would be raised from high net worth individual and also
from the companies . The regulations of this market would be less stringent
due to non involvement of the common people. So Alternate Investment
market would be having the following characteristics :

The regulation of the market would be much more liberal and less
stringent

The players of the market would be high Net Worth Individual and
institutions of capable of taking higher risks

Investment would be in the form of riskier assets

The market operates under high risk- high gain principle

The market would be approached through wealth managers and

investment banks

Since the market is opaque there would be higher possibilities of the

money laundering . So KYC compliance would be of highest order .

Since the sources of money are of higher amount per individual lender
, the enhanced due diligence is required before administering the
scheme

The products would be complex products and mainly structured

products

The chances of failure of the scheme is higher compared to other

traditional scheme.

This source can be a good sources of fund for many business when
traditional market is not able to assess the risk properly. Specially during
the slow down of the economy , the rating agencies and traditional lending
institutions behave more negative way than they should . In this process,
these traditional lenders eliminate good borrowers too. So during this time ,
these good borrowers should avail the Alternate Investment Market ( AIM) .
As of July 2013, Indian economy is going through very negative phase and
this has resulted in the dearth of fund for good borrowers too. During this

time, the AIM can be a very good sources of fund. So we can build some
ground rules when to access the AIM market rather than the traditional
market :

Part funding of promoters equity can be met through the AIM market.
In this type of product, the main lender would be the traditional
lender and the margin money for this senior loan can be brought in
the AIM market . This would work well for the companies which would
be requiring to bring in the margin money for the senior loan

Funding riskier projects where traditional lender would not lend due
to lack of proper assessment of risks. This would be useful for second
or third level of growth of new age business. Venture Capital funding
would be falling in this category

Funding projects where traditional lenders would not be able to lend

due to regulatory restrictions. For example, in India real estate can
not get fund from the baking system due to RBI restriction . So for
real estate funding AIM market can be explored .

Once we have built up fundamental concept of AIM now we shall discuss

about the regulatory fame work of AIM in India. In India the guiding
principle is given as below :

A business entity can raise money in the form of loan from banks and
financial institutions

A business entity can raise money from other entity in the form of
loan provider the number of lender is not more than 50

A business entity can raise money in the form of bond from investors
under Private Placement route provided the number of investors are
not more than 50 only after compliance of Private Placement
regulations as stipulated by SEBI

A business entity can raise money in the form of bond from investors
under Public Issue route provided the number of investors are more
than 50 and in such case the business entity has to comply with the
Public Issue guidelines

Same rule applies for raising fund in the form of equity by the
business entity . The general principle of public issue and private
placement is that if the number of investors are more , more stringent
norms and regulatory compliances are required.

A business entity can raise money in the form of debt or equity from
investors or lenders having number more than 50 but without
following the public issue norms only under the Scheme of AIM
guidelines , Collective Investment Schemes .

Security Exchange Board of India ( SEBI ) has published a comprehensive

regulations called SECURITIES AND EXCHANGE BOARD OF INDIA
(ALTERNATIVE INVESTMENT FUNDS) REGULATIONS, 2012 .

Under this

regulation , Alternative Investment Fund means any fund established or

incorporated in India in the form of a trust or a company or a limited
liability partnership or a body corporate which,(i) is a privately pooled investment vehicle which collects funds from
investors, whether Indian or foreign, for investing it in accordance with a
defined investment policy for the benefit of its investors; and
(ii) is not covered under the Securities and Exchange Board of India (Mutual
Funds) Regulations, 1996, Securities and Exchange Board of India
(Collective Investment Schemes) Regulations, 1999 or any other regulations
of the Board to regulate fund management activities.
However the following exemptions are provided as per the regulations :
1. family trusts set up for the benefit of relatives as defined under
Companies Act, 1956;
2. ESOP Trusts set up under the Securities and Exchange Board of
India (Employee Stock Option Scheme and Employee Stock Purchase
Scheme), Guidelines, 1999 or as permitted under Companies Act,
1956;
3. employee welfare trusts or gratuity trusts set up for the benefit of
employees;

4. holding companies within the meaning of Section 4 of the Companies

Act, 1956;
5. other special purpose vehicles not established by fund managers,
including securitization trusts, regulated under a specific regulatory
framework;
6. funds managed by securitisation company or reconstruction company
which is registered with the Reserve Bank of India under Section 3 of the
Securitisation and Reconstruction of Financial Assets and Enforcement of
Security Interest Act, 2002; and
7. any such pool of funds which is directly regulated by any other regulator

in India;
As per the regulations , we have got clear definitions of certain category of
funds in India. This clarity has come first time and this would help these
types of fund to show a steady growth . These are :
Private equity fund means an Alternative Investment Fund which invests
primarily in equity or equity linked instruments or partnership interests of
investee companies according to the stated objective of the fund;
SME fund means an Alternative Investment Fund which invests primarily in
unlisted securities of investee companies which are SMEs or securities of
those SMEs which are listed or proposed to be listed on a SME exchange or
SME segment of an exchange;
social venture fund means an Alternative Investment Fund which invests
primarily in securities or units of social ventures and which satisfies social
performance norms laid down by the fund and whose investors may agree to
receive restricted or muted returns;

Venture capital fund means an Alternative Investment Fund which invests

primarily in unlisted securities of start-ups, emerging or early-stage venture
capital undertakings mainly involved in new products, new services,
technology or intellectual property right based activities or a new business
model;
Hedge fund means an Alternative Investment Fund which employs diverse
or complex trading strategies and invests and trades in securities having
diverse risks or complex products including listed and unlisted derivatives;
Important Provisions of the Regulations :

Every entity has to take a registration number from SEBI. While

applying for registration , the entity has to specify the objectives of the
schemes and proposed investment details .

For existing VC , the following norms are applicable :

The funds registered as venture capital fund under Securities and Exchange
Board of India (Venture Capital Funds) Regulations, 1996 shall continue to
be regulated by the said regulations till the existing fund or scheme
managed by the fund is wound up and such funds shall not launch any new
scheme after notification of these regulations:
Provided that the existing fund or scheme shall not increase the targeted
corpus of the fund or scheme after notification of these regulations.
Provided further that venture capital funds may seek re-registration under
these regulations subject to approval of two-thirds of their investors by value
of their investment.
The registration would take place under three categories :

Category I Alternate Investment Fund :

Category I Alternative Investment Fund which invests in start-up or early
stage ventures or social ventures or SMEs or infrastructure or other sectors
or areas which the government or regulators consider as socially or
economically desirable and shall include venture capital funds, SME Funds,
social venture funds, infrastructure funds and such other Alternative
Investment Funds as may be specified;
Category II Alternate Investment Fund :
Category II Alternative Investment Fund which does not fall in Category I
and III and which does not undertake leverage or borrowing other than to
meet day-to-day operational requirements and as permitted in these
regulations;
Category III Alternate Investment Fund :
Category III Alternative Investment Fund which employs diverse or complex
trading strategies and may employ leverage including through investment in
listed or unlisted derivatives.
Eligibility Criteria :
For the purpose of the grant of certificate to an applicant, the Board shall
consider the following conditions for eligibility, namely,
(a) the memorandum of association in case of a company; or the Trust Deed
in case of a Trust; or the Partnership deed in case of a limited liability
partnership permits it to carry on the activity of an Alternative Investment
Fund;
(b) the applicant is prohibited by its memorandum and articles of
association or trust deed or partnership deed from making an invitation to
the public to subscribe to its securities;

(c) in case the applicant is a Trust, the instrument of trust is in the form of a
deed and has been duly registered under the provisions of the Registration
Act, 1908;
(d) in case the applicant is a limited liability partnership, the partnership is
duly incorporated and the partnership deed has been duly filed with the
Registrar under the provisions of the Limited Liability Partnership Act, 2008;
(e) in case the applicant is a body corporate, it is set up or established under
the laws of the Central or State Legislature and is permitted to carry on the
activities of an Alternative Investment Fund;
(f) the applicant, Sponsor and Manager are fit and proper persons based on
the criteria specified in Schedule II of the Securities and Exchange Board of
India (Intermediaries) Regulations, 2008;
(g) the key investment team of the Manager of Alternative Investment Fund
has adequate experience, with at least one key personnel having not less
than five years experience in advising or managing pools of capital or in
fund or asset or wealth or portfolio management or in the business of
buying, selling and dealing of securities or other financial assets and has
relevant professional qualification;
(h) the Manager or Sponsor has the necessary infrastructure and manpower
to effectively discharge its activities;
(i) the applicant has clearly described at the time of registration the
investment objective, the targeted investors, proposed corpus, investment
style or strategy and proposed tenure of the fund or scheme;
(j) whether the applicant or any entity established by the Sponsor or
Manager has earlier been refused registration by the Board.

Furnishing the information :

1) The Board may require the applicant to furnish any such further
information or clarification regarding the Sponsor or Manager or nature of
the fund or fund management activities or any such matter connected
thereto to consider the application for grant of a certificate or after
registration thereon.
(2) If required by the Board, the applicant or Sponsor or Manager shall
appear before the Board for personal representation.
Procedure for grant of certificate :
(1) The Board may grant certificate under any specific category of Alternative
Investment Fund, if it is satisfied that the applicant fulfills the requirements
as specified in these regulations.
(2) The Board shall, on receipt of the registration fee as specified in the
Second Schedule, grant a certificate of registration in Form B.
(3) The registration may be granted with such conditions as may be deemed
appropriate by the Board.
Conditions of certificate.
(1) The certificate granted

shall, inter-alia, be subject to the following

conditions:(a) the Alternative Investment Fund shall abide by the provisions of

the Act and these regulations;
(b) the Alternative Investment Fund shall not carry on any other
activity other than permitted activities;

(c) the Alternative Investment Fund shall forthwith inform the Board
in writing, if any information or particulars previously submitted to
the Board are found to be false or misleading in any material
particular or if there is any material change in the information already
submitted.
(2) An Alternative Investment Fund which has been granted registration
under a particular category cannot change its category subsequent to
registration, except with the approval of the Board.
Procedure where registration is refused.

(1) After considering an application made under this regulation, if the Board
is of the opinion that a certificate should not be granted, it may reject the
application after giving the applicant a reasonable opportunity of being
heard.
(2) The decision of the Board to reject the application shall be communicated
to the applicant within thirty days.
(3) Where an application for a certificate is rejected by the Board, the
applicant shall cease to carry on any activity as an Alternative Investment
Fund:
Provided that nothing contained in these regulations shall affect the liability
of the applicant towards its existing investors under law or agreement.

10

Investment conditions and restrictions:

Investment Strategy.
(1) All Alternative Investment Funds shall state investment strategy,
investment purpose and its investment methodology in its placement
memorandum to the investors.
(2) Any material alteration to the fund strategy shall be made with the
consent of at least two-thirds of unit holders by value of their investment in
the Alternative Investment Fund.
Investment in Alternative Investment Fund.

Investment in all categories of Alternative Investment Funds shall be subject

to the following conditions:(a) the Alternative Investment Fund may raise funds from any investor
whether Indian, foreign or non-resident Indians by way of issue of units;
(b) each scheme of the Alternative Investment Fund shall have corpus of at
least twenty crore rupees;
(c) the Alternative Investment Fund shall not accept from an investor,
an investment of value less than one crore rupees:
Provided that in case of investors who are employees or directors of the
Alternative Investment Fund or employees or directors of the Manager,
the minimum value of investment shall be twenty five lakh rupees.
(d) the Manager or Sponsor shall have a continuing interest in the
Alternative Investment Fund of not less than two and half percent of the
corpus or five crore rupees, whichever is lower, in the form of investment in
the Alternative Investment Fund and such interest shall not be through the
waiver of management fees:

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Provided that for Category III Alternative Investment Fund, the

continuing interest shall be not less than five percent of the corpus or
ten crore rupees, whichever is lower.
(e) the Manager or Sponsor shall disclose their investment in the Alternative
Investment Fund to the investors of the Alternative Investment Fund;
(f) no scheme of the Alternative Investment Fund shall have more than
one thousand investors;
(g) the fund shall not solicit or collect funds except by way of private
placement
Placement memorandum :
(1)Alternative
placement

Investment
by

issue

of

Fund

shall

information

raise

funds

through

memorandum

or

private

placement

memorandum, by whatever name called.

(2) Such information or placement memorandum as specified above shall
contain all material information about the Alternative Investment Fund and
the Manager, background of key investment team of the Manager, targeted
investors, fees and all other expenses proposed to be charged, tenure of the
Alternative Investment Fund or scheme, conditions or limits on redemption,
investment strategy, risk management tools and parameters employed, key
service providers, conflict of interest and procedures to identify and address
them, disciplinary history, the terms and conditions on which the Manager
offers investment services, its affiliations with other intermediaries, manner
of winding up of the Alternative Investment Fund or the scheme and such
other information as may be necessary for the investor to take an informed
decision on whether to invest in the Alternative Investment Fund.

12

Schemes :

1) The Alternative Investment Fund may launch schemes subject to filing of

placement memorandum with the Board.
(2) Such placement memorandum shall be filed with the Board at least
thirty days prior to launch of scheme along with the fees as specified in
Provided that payment of scheme fees shall not apply in case of launch of
first scheme by the Alternative Investment Fund.
(3) The Board may communicate its comments, if any, to the applicant prior
to launch of the scheme and the applicant shall incorporate the comments
in placement memorandum prior to launch of scheme.
Tenure :
(1) Category I Alternative Investment Fund and Category II Alternative
Investment Fund shall be close ended and
(2) Category I and II Alternative Investment Fund or schemes launched
by such funds shall have a minimum tenure of three years.
(3) Category III Alternative Investment Fund may be open ended or
close ended.
(4) Extension of the tenure of the close ended Alternative Investment
Fund may be permitted up to two years subject to approval of twothirds of the unit holders by value of their investment in the
Alternative Investment Fund.
(5) In the absence of consent of unit holders, the Alternative
Investment Fund shall fully liquidate within one year following
expiration of the fund tenure or extended tenure.

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Listing :

1) Units of close ended Alternative Investment Fund may be listed on stock

exchange subject to a minimum tradable lot of one crore rupees.
(2) Listing of Alternative Investment Fund units shall be permitted only after
final close of the fund or scheme.

General Investment Conditions.

(1) Investments by all categories of Alternative Investment Funds shall be
subject to the following conditions:(a) Alternative Investment Fund may invest in securities of
companies incorporated outside India subject to such conditions or
guidelines that may be stipulated or issued by the Reserve Bank of
India and the Board from time to time;
(b) Co-investment in an investee company by a Manager or Sponsor
shall not be on terms more favourable than those offered to the
Alternative Investment Fund;
(c) Category I and II Alternative Investment Funds shall invest
not more than twenty five percent of the corpus in one Investee
Company;
(d) Category III Alternative Investment Fund shall invest not
more than ten percent of the corpus in one Investee Company
(e) Alternative Investment Fund shall not invest in associates
except with the approval of seventy five percent of investors by
value of their investment in the Alternative Investment Fund;
(f) Un-invested portion of the corpus may be invested in liquid
mutual funds or bank deposits or other liquid assets of higher

14

quality such as Treasury bills, CBLOs, Commercial Papers,

Certificates of Deposits, etc. till deployment of funds as per the
investment objective;
(g) Alternative Investment Fund may act as Nominated Investor as
specified in clause (b) of sub-regulation (1) of regulation 106N of the
Securities and Exchange Board of India (Issue of Capital and
Disclosure Requirements) Regulations, 2009.
(2) Notwithstanding the conditions as specified in above, the Board may
specify additional requirements or criteria for Alternative Investment Funds
or for a specific category thereof.

Conditions for Category I Alternate Investment Fund :

(1) The following investment conditions shall apply to all Category I

Alternative Investment Funds:(a) Category I Alternative Investment Fund shall invest in investee
companies or venture capital undertaking or in special purpose vehicles or
in limited liability partnerships or in units of other Alternative Investment
Funds as specified in these regulations;
(b) Fund of Category I Alternative Investment Funds may invest in units of
Category I Alternative Investment Funds of same sub-category:
Provided that they shall only invest in such units and shall not invest in
units of other Fund of Funds:
Provided further that the investment conditions as specified in subregulations (2), (3), (4) or (5) shall not be applicable to investments by such
funds.
(c) Category I Alternative Investment Funds shall not borrow funds
directly or indirectly or engage in any leverage except for meeting
temporary funding requirements for not more than thirty days, on not

15

more than four occasions in a year and not more than ten percent of
the corpus.
(2) The following investment conditions shall apply to venture capital
funds in addition to conditions laid down in sub-regulation (1):(a) at least two-thirds of the corpus shall be invested in unlisted equity
shares or equity linked instruments of a venture capital undertaking or
in companies listed or proposed to be listed on a SME exchange or SME
segment of an exchange;
(b) not more than one-third of the corpus shall be invested in:
(i) subscription to initial public offer of a venture capital undertaking whose
shares are proposed to be listed;
(ii) debt or debt instrument of a venture capital undertaking in which the
fund has already made an investment by way of equity or contribution
towards partnership interest;
(iii)

preferential

allotment,

including

through

qualified

institutional

placement, of equity shares or equity linked instruments of a listed company

subject to lock in period of one year;
(iv) the equity shares or equity linked instruments of a financially weak
company

or

sick

industrial

company

whose

shares

are

listed.

Explanation. For the purpose of these regulations, a financially weak

company means a company, which has at the end of the previous financial
year accumulated losses, which has resulted in erosion of more than fifty
percent but less than hundred percent of its net worth as at the beginning of
the previous financial year.
(v) special purpose vehicles which are created by the fund for the purpose of
facilitating or promoting investment in accordance with these regulations:
Provided that the investment conditions and restrictions stipulated in
clause (a) and clause (b) of sub-regulation (2) shall be achieved by the fund
by the end of its life cycle.

16

(c) such funds may enter into an agreement with merchant banker to
subscribe to the unsubscribed portion of the issue or to receive or deliver
securities in the process of market making under Chapter XB of the
Securities and Exchange Board of India (Issue of Capital and Disclosure
Requirements) Regulations, 2009 and the provisions of clause (a) and clause
(b) of sub-regulation (2) shall not apply in case of acquisition or sale of
securities pursuant to such subscription or market making.
(d) such funds shall be exempt from regulation 3 and 3A of Securities and
Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992
in respect of investment in companies listed on SME Exchange or SME
segment of an exchange pursuant to due diligence of such companies
subject to the following conditions:
(i) the fund shall disclose any acquisition or dealing in securities pursuant
to such due-diligence, within two working days of such acquisition or
dealing, to the stock exchanges where the investee company is listed;
(ii) such investment shall be locked in for a period of one year from the date
of investment.
(3) The following conditions shall apply to SME Funds in addition to
conditions laid down in sub-regulation (1):(a) at least seventy five percent of the corpus shall be invested in
unlisted

securities

or

partnership

interest

of

venture

capital

undertakings or investee companies which are SMEs or in companies

listed or proposed to be listed on SME exchange or SME segment of an
exchange;
(b) such funds may enter into an agreement with merchant banker to
subscribe to the unsubscribed portion of the issue or to receive or deliver
securities in the process of market making under Chapter XB of the
Securities and Exchange Board of India (Issue of Capital and Disclosure
Requirements) Regulations, 2009;

17

(c) such funds shall be exempt from regulation 3 and 3A of Securities and
Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992
in respect of investment in companies listed on SME Exchange or SME
segment of an exchange pursuant to due diligence of such companies
subject to the following conditions:
(i) the fund shall disclose any acquisition or dealing in securities pursuant
to such due-diligence, within two working days of such acquisition or
dealing, to the stock exchanges where the investee company is listed;
(ii) such investment shall be locked in for a period of one year from the date
of investment.
(4) The following conditions shall apply to social venture funds in
addition to the conditions laid down in sub-regulation (1):(a) at least seventy five percent of the corpus shall be invested in
unlisted securities or partnership interest of social ventures.
(b) such funds may accept grants, provided that such utilization of such
grants shall be restricted to clause (a).
(c) such funds may give grants to social ventures, provided that appropriate
disclosure is made in the placement memorandum.
(d) such funds may accept muted returns for their investors i.e. they
may accept returns on their investments which may be lower than
prevailing returns for similar investments.
(5) The following conditions shall apply to Infrastructure Funds in
addition to conditions laid down in sub-regulation (1):(a) at least seventy five percent of the corpus shall be invested in
unlisted securities or units or partnership interest of venture capital
undertaking or investee companies or special purpose vehicles, which
are engaged in or formed for the purpose of operating, developing or
holding infrastructure projects;

18

(b) notwithstanding clause (a) of sub-regulation (5), such funds may also
invest in listed securitized debt instruments or listed debt securities of
investee companies or special purpose vehicles, which are engaged in or
formed for the purpose of operating, developing or holding infrastructure
projects.
Conditions for Category II Alternative Investment Funds.

The following investment conditions shall apply to Category II Alternative

Investment Funds:(a) Category II Alternative Investment Funds shall invest primarily in
unlisted investee companies or in units of other Alternative Investment
Funds as may be specified in the placement memorandum;
(b) Fund of Category II Alternative Investment Funds may invest in units of
Category I or Category II Alternative Investment Funds:
Provided that they shall only invest in such units and shall not invest in
units of other Fund of Funds.

(c) Category II Alternative Investment Funds may not borrow funds

directly or indirectly and shall not engage in leverage except for
meeting temporary funding requirements for not more than thirty
days, not more than four occasions in a year and not more than ten
percent of the corpus;
(d) Notwithstanding clause (c), Category II Alternative Investment Funds
may engage in hedging, subject to guidelines as specified by the Board
from time to time;
(e) Category II Alternative Investment Funds may enter into an agreement
with merchant banker to subscribe to the unsubscribed portion of the issue

19

or to receive or deliver securities in the process of market making under

Chapter XB of the Securities and Exchange Board of India (Issue of Capital
and Disclosure Requirements) Regulations, 2009.
(f) Category II Alternative Investment Funds shall be exempt from regulation
3 and 3A of Securities and Exchange Board of India (Prohibition of Insider
Trading) Regulations, 1992 in respect of investment in companies listed on
SME Exchange or SME segment of an exchange pursuant to due diligence of
such companies subject to the following conditions:
(i) the fund shall disclose any acquisition or dealing in securities pursuant
to such due-diligence, within two working days of such acquisition or
dealing, to the stock exchanges where the investee company is listed;
(ii) such investment shall be locked in for a period of one year from the
date of investment.
Conditions for Category III Alternative Investment Funds.

The following investment conditions shall apply to Category III Alternative

Investment Funds:(a) Category III Alternative Investment Funds may invest in securities of
listed or unlisted investee companies or derivatives or complex or
structured products;
(b) Fund of Category II Alternative Investment Funds may invest in units of
Category I or Category II Alternative Investment Funds:
Provided that they invest solely in such units and shall not invest in units
of other Fund of Funds.

20

(c) Category III Alternative Investment Funds may engage in leverage or

borrow subject to consent from the investors in the fund and subject to
a maximum limit, as may be specified by the Board:
Provided that such funds shall disclose information regarding the overall
level of leverage employed, the level of leverage arising from borrowing of
cash, the level of leverage arising from position held in derivatives or in any
complex product and the main source of leverage in their fund to the
investors and to the Board periodically, as may be specified by the Board.
(d) Category III Alternative Investment Funds shall be regulated through
issuance of directions regarding areas such as operational standards,
conduct

of business rules, prudential requirements, restrictions on

redemption and conflict of interest as may be specified by the Board.

Transparency.
All Alternative Investment Funds shall ensure transparency and disclosure
of information to investors on the following:
(a) financial, risk management, operational, portfolio, and transactional
information regarding fund investments shall be disclosed periodically to the
investors;
(b) any fees ascribed to the Manager or Sponsor; and any fees charged to the
Alternative Investment Fund or any investee company by an associate of the
Manager or Sponsor shall be disclosed periodically to the investors;
(c)any inquiries/ legal actions by legal or regulatory bodies in any
jurisdiction, as and when occurred;
(d) any material liability arising during the Alternative Investment Funds
tenure shall be disclosed, as and when occurred;

21

(e) any breach of a provision of the placement memorandum or agreement

made with the investor or any other fund documents, if any, as and when
occurred;
(f) change in control of the Sponsor or Manager or Investee Company.
(g) Alternative Investment Fund shall provide at least on an annual basis,
within 180 days from the year end, reports to investors including the
following information, as may be applicable to the Alternative Investment
Fund:A. financial information of investee companies.
B. material risks and how they are managed which may include:
(i) concentration risk at fund level;
(ii) foreign exchange risk at fund level;
(iii)leverage risk at fund and investee company levels;
(iv) realization risk (i.e. change in exit environment) at fund and
investee company levels;
(v) strategy risk (i.e. change in or divergence from business strategy) at
investee company level;
(vi) reputation risk at investee company level;
(vii)

extra-financial

risks,

including

environmental,

social

and

corporate governance risks, at fund and investee company level.

(h) Category III Alternative Investment Fund shall provide quarterly

reports to investors in respect of clause (g) within 60 days of end of the
quarter;

22

(i) any significant change in the key investment team shall be intimated to
all investors;
(j) alternative Investment Funds shall provide, when required by the Board,
information for systemic risk purposes (including the identification, analysis
and mitigation of systemic risks).
Valuation.

(1) The Alternative Investment Fund shall provide to its investors, a

description of its valuation procedure and of the methodology for valuing
assets.
(2) Category I and Category II Alternative Investment Funds shall
undertake valuation of their investments, atleast once in every six
months, by an independent valuer appointed by the Alternative Investment
Fund:
Provided that such period may be enhanced to one year on approval of
atleast seventy-five percent of the investors by value of their
investment in the Alternative Investment Fund.
(3) Category III Alternative Investment Funds shall ensure that
calculation of the net asset value (NAV) is independent from the fund
management function of the Alternative Investment Fund and such
NAV shall be disclosed to the investors at intervals not longer than a
quarter for close ended Funds and at intervals not longer than a month
for open ended funds.

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Real Estate Investment Trust ( REIT) and Real Estate Investment Fund
( REIF) :
Real Estate Funds are one of the most used financial instruments in the
developed world as an investment tool. They have become popular in the
developed world mainly because it does not have any correlation with the
movements in the equity markets and thus providing diversification
benefits.
With the second largest population in the world, Indias market possesses
inevitable characteristics that will relate strongly to the creation of
enormous real estate pressure and growth in this dynamic sector.
Present Real Estate Structure : The Present Reality :
The Indian economy was a closed market prior to 1991 with recognized real
estate in its infancy in India. Antiquated real estate laws have impeded the
development recently.

The Indian real estate market has traditionally considered illiquid, opaque
and conservative unlike the modern western states where organized real
estate is seen as an avenue for investment and forms a valuable cornerstone
of the economy.
But few years back this changed and the construction business was given
an industry status and some sort of finance flowed into it but not to that
extent. To that end the Indian real estate marketplace has been locked
outside the financial market and not leveraged for investment purposes.
Despite this India is poised for dizzying and rapid urbanization, which will
lead to major developments in Real Estate. However the continued demand
of quality real estate is yet to be achieved due to the shortage of space (Clear

24

Titled Lands) and funds. Secondly developments of new towns and cities,
which are on the anvil, and which India requires drastically, are in the need
of huge amount of investment and technical expertise. This cannot be
achieved under the present practices or by the present domestic developers,
who still work in a much disorganized manner.
The Indian Government is realizing that the Real Estate sector is a key
component of the infrastructure of ant economy and factors inhibiting
growth will have a subsequent negative impact on the economy. The real
estate sector in India has an untapped potential to become a catalyst for
economic growth. This has been demonstrated by the performance of the
industry in other economies but this will only happen if the industry can be
corporatised.

The Indian government has recently allowed the much awaited foreign direct
investment (FDI) in the real estate sector, which is expected to open doors
for much needed investments in the reality sector. However, this requires a
clear understanding of the structure of the industry, its relationship with
the rest of the economy and a focused effort on the reform process. More so
ever this FDI is actually allowed in selected areas only. These investments
would be in integrated township which would include housing, commercial
premises, hotels and resorts, while the urban infrastructure would
compromise roads bridges, mass rapid transit, systems and manufacture of
building materials. The minimum acreage that can be developed is 100
acres designed keeping into consideration the local bylaws and regulations.
The minimum capitalization would be US $ 10 million for a wholly owned
subsidiary and US $ 5 million for a joint venture with an Indian partner. FDI
is however not being allowed in the retail sector.
Real Estate Fund :

25

Real estate funds can be of four types based on the investment tools, which
they use.
Pure Equity Fund : This fund invests in shares of companies, which have
substantial interest (at least 50%) in Real estate sectors, e.g. Construction,
REITs, infrastructure development, etc. this is like any other pure equity
sectoral fund, which has a potential of high returns, accompanied by high
risk brought by a single sector concentration. Examples of such funds are
ABN AMRO Real Estate Fund and AIM Real Estate Fund. These funds invest
in securities of companies, which are in the business of real estate.
Mortgaged Backed Securities Fund : This kind of funds invests in
mortgaged backed securities of companies by investing directly in these
companies or by buying mortgage backed securities. This is very new in
India and not much used here as of now.
Hybrid Fund : This kind of fund invests in shares and mortgaged backed
debt instruments issued by companies involved in the real estate sectors or
generate a substantial part of their business from the real estate sector. This
again is nothing but a hybrid sectoral fund and has higher sector specific
risk attached to it. An example of such a fund is Gaa Blueprint Property
Fund. It is a UK based fund, which invests in real estate equity, debt
instruments issued by real estate firms, property trusts funds and
commercial property funds.
Real Estate Investment Trust ( REIT) : This kind of fund will invest in
different kinds of Real Estate properties like Retail Stores, Industrial
Properties, Commercial Properties and Residential Properties, etc. and earn
their income from rents, lease payments and possible appreciation of the
value of these properties. Examples of such funds are Norwich Property
Fund and Guardian Property Fund.
Baring the last one i.e. Real Estate Investment Trust, the first three kind of
funds cab be launched in India as per the current SEBI regulations, the only

26

problem they might face in India is that there arent many company listed in
India which have substantial part of their business in Real Estate. As of now
the India laws do not allow us to form a Real Estate Investment Trust, but
the finance ministry, SEBI and RBI have taken steps and are trying to evolve
a route to introduce a Real Estate Investment Trust.

REMF Framework :

INVESTOR is the one who has an affinity towards realty investments.

Investor profile can range from Insurance Companies, Corporate Bodies to
Retail Investors. The Investors are the source of funds in the whole
framework.
REAL ESTATE MUTUAL FUND or the REMF acts as a conduit or a link
between an investor and real estate and helps manage the funds of the
investors

and

invest

them

in

the

real

estate

sector.

INVESTMENTS: REMF can invest in a developed property, and as the value

appreciates over a period of time, it can offload its investment to make
capital gains. It also has an option of developing the property on its own and
then selling it at an appropriate time to ensure adequate returns.
Furthermore, it can realize regular stream of returns through leasing,
financing to developers and mortgage backed financing. The Investment
Avenues

are

the

users

of

funds

in

the

whole

framework.

The FUNCTIONS, which REMF performs, includes entering into Real Estate
Transactions on behalf of its investors, performing valuations of the
properties either internally or through external agencies. The REMF is also
responsible in maintaining liquidity in case of any redemption pressures or
to fulfil any financial obligations or to undertake trades. The REMF is also
responsible for maintaining the properties, which it has brought under its
control.
The REGULATORY BODIES involved in the working of REMF include the
Finance Ministry, the SEBI, the RBI and any other body as per the rules
formed by the concerned authority.

27

Real Estate Investment Trust :

A Real Estate Investment Trust (REIT) is a company that invests its assets in
real estate holdings. Investors get a share of the earnings, depreciation, etc.
from the portfolio of real estate holdings that the REIT owns. Thus, investors
get many of the same benefits of being a landlord without too many of the
hassles. Investors also have a much more liquid investment than investors
do when directly investing in real estate. The downsides are that investors
have no control over when company will sell its holdings or how it will
manage them, like you would have if investors

owned an apartment

building.
Advantages :
REIT is a company that buys, develops, manages and sells real estate
assets. REITs allow participants to invest in a professionally managed
portfolio of real estate properties. REIT qualify as pass through entities,
companies who are able distribute the majority of income flows to investors
without taxation at the corporate level (providing that certain conditions are
met). As pass through entities, whose main function is to pass profits on to
investors, a REITs business activities are generally restricted to generation
of property rental income. Another major advantage of REIT investment is
its liquidity (ease of liquidation of assets into cash), as compared to
traditional private real estate ownership which are not very easy to liquidate.
One reason for the liquid nature of REIT investments is the its shares are
primarily traded on major exchanges, making it easier to buy and sell REIT
assets/shares than to buy and sell properties in private markets.
Essentially, REITs are the same as stocks, only the business they are
engaged in is different than what is commonly referred to as stocks by
most

folks.

Common

stocks

are

ownership

shares

generally

in

manufacturing or service businesses. REITs shares on the other hand are

the same, just engaged in the holding of an asset for rental, rather than
producing a manufactured product. In both cases, though the shareholder

28

is paid what is left over after business expenses, interest/principal, and

preferred shareholders dividends are paid. Common stockholders are always
last in line, and their earnings are highly variable because of this. Also,
because their returns are so unpredictable, common shareholders demand a
higher expected rate of return than lenders (bondholders). This is why equity
financing is the highest cost form of financing for any corporation.
An interesting thing about REITs is that they are probably the best inflation
hedge around. However, they almost always lack the potential for
tremendous price appreciation (and depreciation) that you get with most
common stocks. There are exceptions, of course, but they are few and far
between.
Investors should pick several REITs instead of one. They are subject to
ineptitude on the part of management just like any companys stock, so
diversification

is

important.

However,

they

are

rather

conservative

investment, with long term returns lower than common stocks of other
industries. This is because rental revenues do not usually vary as much as
revenues at a mfg. or service firm.
Types of REITs :
REITs fall into three broad categories:

EQUITY REITs

Equity REITs invest in and own properties (thus responsible for the equity or
value of their real estate assets). Their revenues come principally from their
properties rents.

Mortgage REITs:

29

Mortgage REITs deal in investment and ownership of property mortgages.

These REITs loan money for mortgages to owners of real estate, or invest in
(purchase) existing mortgages or mortgage backed securities. Their revenues
are generated primarily by the interest that they earn on the mortgage loans.

Hybrid REITs :

Hybrid REITs combine the investment strategies of Equity REITs and

Mortgage REITs by investing in both properties and mortgages.
Individual REITs are able to distinguish themselves by specialization. REITs
may focus their investments geographically (by region, or metropolitan area),
or in property types (such as retail properties, industrial facilities, office
buildings, apartments or healthcare facilities). Certain REITs choose a
broader focus, investing in a variety of types of property and mortgage
assets across a wider location and different categories of assets and thus
ensuring proper diversification. This would help investors to reduce the
risks.
REITs are dividend paying stocks that focus on real estate. If investors seek
income, investors would consider them along with high yield bond funds
and dividend paying stocks. Investors can see that stable dividends combine
with price volatility to create a total return which is often promising, but
volatile nonetheless.
Introducing REITs to the Indian market place requires a favourable legal,
regulatory, accounting and tax system and environment. Presently, the
introduction and facilitation of the REIT concept is still in the planning
stages with the securities exchange bureau of India (SEBI), Reserve Bank of
India (RBI) and the Finance Ministry evolving a blue print for customizing
REITs for the Indian marketplace and formulating the changes in
regulations required to enable this structure. With that in mind the
association of mutual funds of India (AMFI) formed a Sub-Committee. The

30

mandate of this committee called the Satwalekar Committee was to

formulate a working plan for real estate investment schemes based on their
findings and to propose recommendations for change to the government.

SATWALEKAR COMMITTEE:

The Satwalekar Committee conducted a detailed study and has prepared an

exhaustive report on the above subject and formulated a working plan for
launching Real Estate Investment Schemes (REIS) based on the Committee
recommendations.

The Structure :

The Sub-committee deliberated on the appropriate structure to be

recommended for the introduction of the real estate funds in the country.
the deliberations focused on two different models:
Real Estate Investment Trust of USA, which have been in operation since
1962 and The Mutual Fund Structure prevalent in UK.

The favoured model for India being that prevalent in the UK the pooled
managed vehicle (PMV) a Mutual Fund Structure. In the United Kingdom,
real estate investments are done through pooled managed vehicles. While
these are different from open ended Investment companies (OICs), they can
be in the form of trusts. The regulator for these however, have a variable
capital and are similar to open ended funds. PMVs may get tax qualify for
benefits. However, there are no tax benefits for the regular PMVs. This would
be comparable to have no tax benefits for typical OICs. The PMV has ability
to delay redemption if there is excessive pressure to exit the fund.

31

In this context, the sub-committee has been able to suggest a solid

investment program by evaluating international experience regarding Real
Estate Funds in other countries and has a looked to the points of liquidity
and

low

volatility,

Professional

management,

Conservative

leverage,

Diversification of investment risk, Independent monitoring and Technology

transfer.
In the United States real estate investment is through real estate investment
trusts (REITs). The REITs are formed as companies that have an issued
share capital. Further, they have the flexibility to raise funds through
preference shares and debt. In this structure they are always close ended
and listed on the exchanges. In order to qualify as an American REIT the
following rules have to be followed:

Be an entity that is taxable as a corporation.

Be managed by a board of directors or trustees.

Have shares that are fully transferable.

Have a minimum of hundred shareholders.

Have no more than 50% held by five or fewer individuals during the
last half of each taxable year.

Invest at least 75% of the total assets in the real assets.

Invest at least 75% of gross income from real property, or interest on

mortgages on real property.

Have no more than 20% of its assets consist of stocks in taxable REIT
subsidiaries.

Pay dividends of at least 90% of its taxable income form of

shareholder dividends.

REITs were started without tax benefits and did not do well until the
US tax laws were amended in 1986. The new laws provided them with
tax benefits under the condition that they conform to certain
requirements that have been laid down. REITs are very popular now in
United States. as per the data available, there are approximately 300
REITs operating in the country with assets in excess of US$300

32

billion. The company structure followed in the USA (REITs), which

allows the flexibility to raise funds by leveraging the balance sheet,
was deemed inappropriate by the sub-committee for pooling of small
savings in the area of Real Estate Investment.
The PMVs in UK are in the form of trusts and similar to the open ended
Mutual Funds/Collective Investment Schemes. Which are regulated by
SEBI. The sub-committee has therefore recommended the trust structure
as appropriate for Real Estate Investments.

It should be noted that REITs in the US became popular structure for

investing in Real estate only after the US Congress granted them tax
benefits. After comparison of the features and suitability of the collective
investment scheme structure versus the mutual fund structure for real
estate

investments,

the

securities

and

exchange

board

of

India

determined that the (Collective Investment Scheme (CIS) Regulations, of

1999 (CIS Regulations) would have to be modified to include real estate
as an investment objective and to enable and launch Indianized REITs of
REMFs.

Recommended Changes in the CIS Regulations :

Some of the problems with the CIS regulations in India are as follows:
The CIS regulations do not have a concept of a sponsor. Thus any
company having a net worth of Rs 5 crores and the appropriate main
objectives in its articles of association can set up a collective investment
scheme. This needs to be rectified and only companies with a sound
financial background should be allowed to set up collective investment
schemes based REIT. Due the lack of a sponsor for the business, the CIS
Regulations do not seem to be emphasize the concept of arms length
relationships between group companies. this concept is very important
for investor safeguard and should specify the upper limit for the exposure

33

that the REIT can take on group companies projects and projects of its
majority shareholders.

The CIS regulations appear to be made keeping a specific project in mind.

The regulations prescribe a maximum subscription level and recommend
proportionate allotment of units. It may be noted that real estate funds
are not project specific and therefore do not have predetermined size of
subscription. So

keeping a maximum limit on subscription would

disadvantage small investors desirous of taking exposure to the real

estate sector.
Being

fundamentally

regulations

do

not

based
have

on
any

specific

investment

project

rationale,

restrictions.

CIS

Extensive

investment restrictions were recommended by the Deepak Satwalekar

Committee to avoid over exposure to certain projects, groups or
geographic locations. Investment restrictions are vital for ensuring safety
of the investors monies. It should
regulations

contain

investment

also noted that the existing MF

restrictions

similar

to

the

ones

recommended by the Satwalekar Committee.

Another issue with the CIS regulations is the concept of an appraising

agency. This is again appropriate for a specific project that would need to
be appraised, as a measure of abundant caution. The appraisal concept
is misplaced in a situation where multiple properties are being invested
in. Also, the appraising concept reduces the flexibility of the managers of
the

scheme

and

may

impair

the

possibility

of

better

returns.

Another important aspect of CIS is that the CIS Regulations do not

necessitate the calculation of NAV. Thus, there is no underlying value of
the investments or the units that can be calculated on an on going basis.
Thus, Real Estate investments done under the CIS Regulations would not

34

provide a fair and transparent underlying NAV, against which the market
price could be benchmarked.

It should be noted that in the case of

pooled managed vehicles in the UK, valuation of properties is done on a

quarterly basis and NAV is reported on a daily basis. Thus, even the
international experience suggests NAV calculation as a central concept of
Real Estate Investment.
Finally, tax benefits available to mutual funds are a vital determinant of
the success of the domestic mutual fund industry. If we

recall the

experience of the USA where REITs gained popularity after receiving tax
benefits.
The need of appropriately structured Real Estate investments can be
hardly overemphasized. It may be noted that the Deepak Satwalekar
Committee went into great detail on the benefits of Real Estate Funds,
including channeling small savings into the housing sector, which
currently faces a huge shortage, as well as providing investors with
another

investment

alternative,

hitherto

unavailable.

It is suggested that the mutual fund structure for introducing Real Estate
investments in India

is preferable. Post the issuing of comprehensive

guidelines by SEBI, the mutual fund structure is now well understood

and trusted. Selling of real estate investments through the mutual fund
route would therefore be easier and energies can be directed towards
selling the product rather than the structure. There are many different
structures, which can be used to form a real estate fund, one such
structure, which can be very successful, is the Interval Mutual Fund
structure. An example
Be

close

ended

of an Interval structure

for

minimum

period

is given below:
of

years.

Open at the end of every quarter for sale of fresh units based on the
quarterly NAV calculation and remain open for a minimum period of 15
days. This will enable the fund to grow by soliciting fresh inflows from
investors, while giving potential investors a chance to participate in the
scheme after its Initial Offer.

35

Offer redemption / repurchase to the investors at the end of 3 years in a

staggered manner. For example, at the end of 3 years, 20% of the
investment can be redeemed at NAV; at the end of 5th year, balance 30%
can be redeemed to the investor at NAV.

Be an interval fund, and offers redemption at the end of 3 years, the

scheme may be listed on any stock exchange to provide the liquidity to
the investors.

Calculate the NAV on quarterly basis as per the valuation of the

underlying investments. Operate within the regulations of Mutual Funds
as amended from time to time and comply with all the requirements of
the SEBI (Mutual Fund) Regulations.
Tax benefits :Being part of a Mutual Fund, Real Estate Investment
Schemes would be eligible for all tax benefits applicable to Mutual Funds
in general. This would enhance the attractiveness of these schemes to
investors.
The scheme will not be allowed to borrow funds from the market and
thus use leverage so as to enhance the risk return paradigm.
No matter what the structure of the real estate scheme is but it is
expected that the investment avenues will be restricted to the list given
below:

Equity Shares / Bonds / Debentures of the listed companies which deal

in properties along with property development. however, at present, in
India

there

are

very

few

such

companies,

which

are

listed.

Mortgage-backed securities i.e. the securitisation of housing loans.

At present, these are not yet available. Direct estate project finance,
construction finance, purchase / option to purchase of buildings under

36

construction with a view to sell it again; investment in the debt securities

issued by development and construction companies (placed privately).
Investments in money markets and call markets so as to maintain the
required liquidity.

Launching REITs in India :

Before launching a REMF, all Real Estate Investment Schemes would

need the approval of SEBI and will also have to file the Offer Document
as per the existing SEBI (Mutual Fund) Regulations. An asset
Management company could launch these Schemes if it has the
appropriate investment management skills and if not then it can use the
services of an advisor.

There are certain risks associated with investing in Real Estate as an

asset class. Some of these risks are given below:

Liquidity Risk

Risk because of high maintenance burden.

Risk due to high government controls

Risk due to real estate cycles

Risk due to legal hurdles and complexity

Risk due to high transaction cost and thus forming barriers to

entry and exit.

Risk due to lack of information

Some of these risks are natural and inevitable but a lot of these risks can
be controlled to some extent. A Real estate mutual fund should work in

37

such a way that the over all risk is optimized and matched to the
investors needs.
Risk Management :
Amendment in SEBI As recommended by the Satwalekar Committee, an
amendment in SEBI regulations is suggested enabling the SEBI to
regulate the establishment and functioning of the real estate mutual
funds schemes with all the existing regulations applicable to such
mutual funds pertaining to net worth of AMC; existing free structure;
initial launch expenses restricted at 6%; maximum limit of expenses; etc.
as

already

provided

in

the

Mutual

Fund

regulations.

Investment Restriction That present Regulations have restriction on

investment where any investment in one corporate should be restricted
up to 10% of the corpus and similarly, any investment in the properties
owned and managed by sponsor should be restricted upto 25% of the
corpus.

Restriction based on project, Promoter Group and Geographical area

The Satwalekar Committee has recommended Investment Restrictions
based on a project, a promoter group and a geographical area. With these
restrictions appropriate ti mitigate the concentration risk of the
investment portfolio of the real estate investment scheme. Details of the
investment restrictions proposed in the report of the Satwalekar
Committee

can

be

found

on

page

24

of

that

report

Valuation At present, we have Registered Valuers as proved by

Government of India / Income tax Departments / Insurance Regulatory
Development Authority. Thus it becomes imperative for SEBI to use them
and approve these registered valuers for the purpose of valuing properties
held by Real Estate Investment Schemes.
Legal Aspects that need change :

38

Along with the regulatory issues, there are some legal issues that are
caused by our antiquated laws and which will hamper the smooth and
profitable functioning of the Real Estate Mutual Funds. thus these laws
need to be reformed since they also increase the risk level of a Real
Estate Investment. Some of these laws and proposed changes are given
below:

Stamp Duty This is a state subject and unless the Central Government
decides to make it uniform, it will be difficult and time consuming to
expect any changes in the stamp duty framework. It is recommended
that either there should be no stamp duty for a SEBI registered REMF or
even if a minor stamp duty is imposed it should take the form of value
added stamp duty structure and thus double stamp duty will be avoided
in

case

of

frequent

transfer

of

the

properties.

Property Taxes this is a State/City subject. It recommended that the

relevant authorities provide exemption from annual property taxes to real
estate investment schemes. This would help real estate investment
schemes

to

provide

better

returns

to

investors.

Records A significant issue in dealing with properties is the custody if

title and paper form of transaction. It would be very helpful to the REMF
if all the property records are computerized and the properties be
transacted in a dematerialized format, exactly how the securities are
traded right now.
Rent Control Act The provisions of the Rent Control Act have been
amended in some of the states. since, several states continue with the
ancient Rent Control provisions and it is believed that the Rent Control
Act is one of the main reasons why people are not very enthusiastic in
building a house and giving it on rent.

Urban Land Ceilings and Regulations Act This act lays a ceiling
(generally around 500 to 2000 square meter) on the land which a person

39

can hold in an urban area, the excess land is either to be handed over to
a competent authority or is to be developed by the owner for a specified
purposes only. Here a person stands for an individual, corporation, firm,
family, association or body of individuals etc. Thus if the REIT has to
come to any meaningful existence this law has to be scrapped.

It can be concluded that there is a tremendous potential for a Real Estate

Hedge Fund to be introduced in India. The proposed fund will mainly
follow the structure already being followed in UK, which is that of a
Mutual Fund with some changes. Though the demand for such a fund is
huge there are a lot of concerns, which are still to be answered in terms
of the antiquated laws, which govern the real estate business, the
existing laws of SEBI and regulatory mechanisms to be used. If these
concerns are taken care off by the government then the proposed real
estate funds are poised to have exponential growth in India and thereby
lead to greater economic growth and overall progress of the country.

Hedge Fund :
A hedge fund is a limited-partnership fund that invests private capital
speculatively to maximize capital appreciation. They invest in a diverse
range of markets, investment instruments, and strategies. Though they
are privately owned and operated, hedge funds are subject to the
regulatory restrictions of their respective countries. U.S. regulations, for
example, limit hedge fund participation to certain classes of accredited
investors. Hedge fund sources fund from High Net-worth Individual ( HNI)
as well as from Institutions. These funds operate with a lean operating
structure and uses different strategies to maximize the income. The fund
is not risk averse in nature. However the hedge fund strategy and under
lying operations have shifted to great extent post 2008 crisis which we
shall discuss in the detail later on.

40

A hedge fund typically pays its investment manager an annual management

fee, which is a percentage of the assets of the fund, and a performance fee if
the fund's net asset value increases during the year. Some hedge funds have
a net asset value of several billion dollars. As of 2009, hedge funds
represented 1.1% of the total funds and assets held by financial
institutions. As of 1st Quarter 2013, total assets under management for the
hedge fund industry was $1865.5 billion, and the managed futures (CTA)
industry was $337.2 billion.[ Source www.barclayhedge.com]. Detail sector
wise break up of hedge fund assets are given below :
Hedge Fund Industry - Assets Under Management
Assets Under
Management
Hedge Funds *
Funds of
Funds

1st Qtr
13

4th Qtr 12

3rd Qtr 12

$1865.5B

$1798.7B

$1827.3B

$485.5B

$501.4B

$515.1B

$38.6B

$38.9B

$39.9B

$142.6B

$124.4B

$120.7B

$232.5B

$211.6B

$211.8B

$163.8B

$149.9B

$151.0B

$176.9B

$170.2B

$176.0B

Sectors
Convertible
Arbitrage
Distressed
Securities
Emerging
Markets
Equity Long
Bias
Equity

41

Long/Short
Equity Long-

$59.5B

$53.5B

$87.2B

$20.2B

$23.2B

$28.8B

Event Driven

$174.4B

$164.8B

$168.7B

Fixed Income

$287.5B

$280.6B

$263.0B

Macro

$167.6B

$172.9B

$171.5B

$24.0B

$24.2B

$24.5B

Multi-Strategy

$241.6B

$239.7B

$242.1B

Other **

$30.3B

$33.3B

$29.8B

$106.2B

$111.6B

$112.3B

Only
Equity Market
Neutral

Merger
Arbitrage

Sector Specific
***

Industry-wide estimated in USDBillions

*Excludes Fund of Funds assets
**Other: Include funds categorized as Regulation D, Equity ShortBias,
Option Strategies, Mutual Fund Timing, Statistical Arbitrage, Closed-End
Funds, Balanced, Equity

Dedicated Short and without a

category.

***Sector Specific: Includes sector funds categorized as Technology, Energy,

Bio-Tech, Finance, Real Estate, Metals & Mining and Miscellaneous
oriented.
[ Sources : www.barclayhedge.com]

42

Once we have discussed about the different categories of asset class within
the Hedge fund , now we shall see how Hedge Fund contributes to the
overall Alternate Investment Market :

(*Includes CTAs and Hedge Funds)

Source : www.barclayhedge.com
The above data shows that the Hedge fund and CTA as a percentage of the
Alternative Investment Industry has started declining 2000 and then it
reached its nadir in the year 2007. However after that it started showing
going up with a slight drop in 2012. This is due to the reason that post
subprime crisis the overall Alternative Investment Industry suffered due to
the liquidity crisis and Hedge fund also suffered. However , Hedge Fund as a

43

percentage of the total investment has gone up due to lack of other avenues
of the Alternative Investment Industry and better regulations of the Hedge
Fund Industry.
During the US bull market of the 1920s, there were numerous private
investment vehicles available to wealthy investors. One of the most popular
funds during that time is the Graham-Newman Partnership founded
by Benjamin Graham and Jerry Newman . This is considered one of the
early hedge funds.
Financial journalist Alfred W. Jones is credited with coining the phrase
"hedged fund" and is wrongly quoted as the creator of the first hedge fund
structure in 1949. Jones referred to his fund as "hedged", a term then
commonly used on Wall Street, to describe the management of investment
risk due to changes in the financial markets. However this is not the true
spirit of the Hedge Fund what we hear today. In 1968 there were almost 200
hedge funds, and the first fund of funds that utilized hedge funds were
created in 1969 in Geneva .In the 1970s hedge funds specialized in a single
strategy, and most fund managers followed the long/short equity model.
As happened in the past , due to recession and adverse economic situation
many hedge funds closed, for example : many hedge funds closed during
the recession of 196970 and the 19731974 stock market. They received
renewed attention in the late 1980s. During the 1990s the number of hedge
funds increased significantly, funded with wealth created during the 1990s
stock market rise. It shows that immediately after wealth creation , hedge
fund industry boomed. The increased interest was due to the alignedinterest compensation structure (i.e. common financial interests) and the
promise of above high returns. Over the next decade hedge fund started
using multiple strategies with the use of computers and other sophisticated
modelling techniques . These

strategies expanded to include: credit

arbitrage, distressed debt, fixed income, quantitative, and multi-strategy. US

institutional investors such as pension and endowment funds began
allocating greater portions of their portfolios to hedge funds . The main

44

interest of these entities were to generate higher amount of return from their
investment .
During the first decade of the 21st century, hedge funds gained popularity
worldwide

and

by

2008,

the

worldwide

hedge

fund industry

held

US$1.93 trillion in assets under management (AUM).However, the 2008

financial crisis caused many hedge funds to restrict investor withdrawals
and their popularity and AUM totals declined. AUM totals rebounded and in
April 2011 were estimated at almost $2 trillion. Now since 2008 crisis ,
hedge fund investors profile has undergone change with more and more
institutional investors investing in the hedge fund. As of February 2011,
61% of worldwide investment in hedge funds comes from institutional
sources. In

June

2011,

the

greatest AUM was Bridgewater

hedge

funds

with

the

Associates (US$58.9 billion), Man

Group (US$39.2 billion), Paulson & Co. (US$35.1 billion), Brevan Howard
(US$31 billion), and Och- Ziff

(US$29.4 billion). Bridgewater Associates,

had $70 billion under management as of 1 March 2012. At the end of that
year, the 241 largest hedge fund firms in the United States collectively held
$1.335 trillion. In April 2012, the hedge fund industry reached a record high
of US$2.13 trillion total assets under management.
Strategies :
Hedge fund employs lot of strategies to increase the return. However
classifying them is difficult due to rapid change in the same over time.
Broadly we can segregate the Hedge Fund Strategies into four categories :

45

Hedg
ge Fund
Traading
Straategies

Glob
bal Macro

Relativ
ve Value
( Arbiitrage)

Eventt Driven

Direectional

Global Macro Strrategies :

Hedge

funds

utilizing

global

macro

investting

stra
ategy

tak
ke

sizable positions in share, bond orr currency

y markets
s in antic
cipation o
of
global macroecon
m
nomic

ev
vents in

o
order

to

generatte

ris
sk-adjuste
ed

return. Global macro

m
fund manage
ers use macroecon
m
nomic ("biig picture
e")
analysis
s based on
n global market
m
eve
ents and trrends to identify op
pportunitie
es
for inve
estment th
hat would
d profit fro
om anticip
pated pric
ce moveme
ents. Whille
global macro
m
stra
ategies hav
ve a large amount of
o flexibilitty due to their
t
abilitty
to use leverage to
t take la
arge positiions in div
verse inve
estments in
i multiplle
markets
s, the tim
ming of the
e implemen
ntation off the strate
egies is im
mportant in
i
order to generate attractiv
ve, risk-ad
djusted re
eturns. Gllobal mac
cro is ofte
en
categorrized as a directional
d
l investme
ent strateg
gy.
Global macro strrategies can be div
vided into discretion
nary and systematiic
approac
ches. Disc
cretionary trading iis carried out by in
nvestmentt managerrs
who

identify

a
and

selec
ct

investtments; sy
ystematic

trading

is

base
ed

on math
hematical models and
a
execu
uted by software
s
w
with limite
ed huma
an
46

involvement beyond the programming and updating of the software. These

strategies can also be divided into trend or counter-trend approaches
depending on whether the fund attempts to profit from following trends (long
or short-term) or attempts to anticipate and profit from reversals in trends.
Within global macro strategies, there are further sub-strategies including
"systematic diversified", in which the fund trades in diversified markets, or
"systematic currency", in which the fund trades in currency markets. Other
sub-strategies include those employed by Commodity Trading Advisors
(CTA), where the fund trades in futures (or options) in commodity markets
or in swaps. This is also known as a managed future fund. CTAs trade in
commodities (such as gold) and financial instruments, including stock
indices. In addition they take both long and short positions, allowing them
to make profit in both market upswings and downswings.

Directional
Directional investment strategies utilize market movements, trends, or
inconsistencies when picking stocks across a variety of markets. Computer
models can be used, or fund managers will identify and select investments.
These types of strategies have a greater exposure to the fluctuations of the
overall market than do market neutral strategies. Directional hedge fund
strategies include US and international long/short equity hedge funds,
where long equity positions are hedged with short sales of equities or
equity index options.
For example , hedge fund manager may think that the equity of a particular
stock would go up. It would take a long position on the equity and it would
hedge the same with the short position with the futures.

Long and Short Equity :

47

This strategy involves investments, long or short, in equities. Traditional

equity value and growth hedge funds purchase stocks which they perceive to
be undervalued and sell stocks which they perceive to be overvalued. The
research-intensive efforts employed in identifying promising stocks to hold
long in a portfolio may also provide short-sale opportunities, and for this
reason many directional equity funds often maintain both long and short
portfolios. While the long side generally outweighs the short side in most
directional equity funds, there is also a small group of short-biased funds in
which the short side as a general matter exceeds the long side, sometimes
by a significant margin.
Within directional strategies, there are a number of sub-strategies.
"Emerging markets" funds focus on emerging markets such as China and
India, whereas

"sector

funds"

specialize

in

specific

areas

including

technology, healthcare, biotechnology, pharmaceuticals, energy and basic

materials. Funds using a "fundamental growth" strategy invest in companies
with more earnings growth than the overall stock market or relevant sector,
while funds using a "fundamental value" strategy invest in undervalued
companies. Funds that use quantitative techniques for equity trading are
described as using a "quantitative directional" strategy. Funds using a
"short bias" strategy take advantage of declining equity prices using short
positions.

There are many difficulties with managing long/short funds. These include
the difficulties of estimating and hedging the risks to which a portfolio is
exposed, and the requirement to manage unsuccessful short positions in an
active manner. Short positions that are losing money grow to become an
increasingly large part of the portfolio, and their price can increase without
limit.

However, the major difficulty is that to make money the hedge fund must
successfully predict which stocks will perform better. Most investors grossly
underestimate the difficulty of this task. It requires making intelligent use of

48

the available information, but this is not enough -- it also requires making
better use of the available information than large numbers of capable
investors.

Event-driven
Event-driven

strategies

concern

situations

in

which

the

underlying

investment opportunity and risk are associated with an event. An eventdriven investment strategy finds investment opportunities in corporate
transactional events such as consolidations, acquisitions, recapitalizations,
bankruptcies, and liquidations. Managers employing such a strategy
capitalize on valuation inconsistencies in the market before or after such
events, and take a position based on the predicted movement of the
security or securities in question. Large institutional investors such as
hedge funds are more likely to pursue event-driven investing strategies than
traditional equity investors because they have the expertise and resources to
analyze

corporate

transactional

events

for

investment

opportunities.

Corporate transactional events generally fit into three categories:

1. distressed securities,
2. risk arbitrage and
3. special situations.
Distressed

securities :

It

includes

such

events

as

restructurings,

recapitalizations, and bankruptcies. Distressed securities are securities of

companies or a nation's central bank that are either already in default,
under bankruptcy protection, or in distress and heading toward such a
condition. When it comes to fixed income, these types of securities are below
investment grade, and can include corporate credit as well as emerging
market government fixed income. The most common distressed securities
are bonds and bank debt. While there is no precise definition, fixed income
instruments with a Yield to Maturity in excess of 1000 basis points over the
risk-free rate of return (e.g. Treasuries) are commonly thought of as being

49

distressed. A related category is stressed debt yielding between 600-800

basis points over Treasuries.
Historically, distressed securities have traded at deep discounts to a rational
assessment of their risk-adjusted value for a number of reasons. For
example, banks or institutional investors often have constraints that prevent
them from investing in such risky securities. This has led to above average
returns (adjusted for risk) from investors in this asset class. In recent years,
the amount of capital devoted to the distressed securities sector has
increased.
A distressed securities investment strategy involves investing in the bonds
or loans of companies facing bankruptcy or severe financial distress, when
these bonds or loans are being traded at a discount to their value. Hedge
fund managers pursuing the distressed debt investment strategy aim to
capitalize on depressed bond prices. Hedge funds purchasing distressed
debt may prevent those companies from going bankrupt, as such an
acquisition deters foreclosure by banks. While event-driven investing in
general tends to thrive during a bull market, distressed investing works best
during a bear market.
Risk arbitrage or merger arbitrage : It includes such events as mergers,
acquisitions, liquidations, and hostile takeovers. Risk arbitrage typically
involves buying and selling the stocks of two or more merging companies to
take advantage of market discrepancies between acquisition price and stock
price. The risk element arises from the possibility that the merger or
acquisition will not go ahead as planned; hedge fund managers will use
research and analysis to determine if the event will take place. Special
situations are events that impact the value of a company's stock, including
the restructuring of a company or corporate transactions including spinoffs, share-buy-backs, security issuance/repurchase, asset sales, or other
catalyst-oriented situations. To take advantage of special situations the
hedge fund manager must identify an upcoming event that will increase or
decrease the value of the company's equity and equity-related instruments.

50

Other event-driven strategies include: credit arbitrage strategies, which

focus on corporate fixed income securities; an activist strategy, where the
fund takes large positions in companies and uses the ownership to
participate in the management; a strategy based on predicting the final
approval of new pharmaceutical drugs; and legal catalyst strategy, which
specializes in companies involved in major lawsuits.
Relative value
Relative value arbitrage strategies take advantage of relative discrepancies in
price between securities. The price discrepancy can occur due to mispricing
of securities compared to related securities, the underlying security or the
market overall. Hedge fund managers can use various types of analysis to
identify

price

discrepancies

in

securities,

including

mathematical, technical or fundamental techniques. Relative value is often

used as a synonym for market neutral, as strategies in this category
typically have very little or no directional market exposure to the market as
a whole. Other relative value sub-strategies include:

Fixed income arbitrage: exploit pricing inefficiencies between related fixed

income securities :

Fixed Income Arbitrage (FIA) is the name given to a family of trading

strategies that, to various extents, use spread trades on debt
instruments to take advantage of pricing inefficiencies independent of
overall market direction. A spread trade is the simultaneous purchase
and shorting of related securities (and their derivatives) in the hope of
profiting from the widening or narrowing of the spread (i.e. the prices)
between the two securities. FIA typically deal with large quantities of
highly liquid debt instruments, such as government and corporate
bonds, asset-backed securities, and debt-related derivatives like
swaps, futures, and options. Positions are usually leveraged from 5 to
15 times the asset bases value, although there is no hard and fast
rule concerning this.

51

Because FIA spreads contain long and short legs, they tend to cancel
out systematic market risks, such as changes to the yield curve.
Managers are free to hedge away specific risk exposures, including
risks due to changes in interest rates, creditworthiness, foreign
exchange risks, and default, though the extent of hedging employed
varies greatly among hedge fund managers. Managers are also free to
take directional positions instead of relying solely on pure neutral
hedges.

Spreads available to FIA traders are typically small, which is why

leverage is widely employed. Leverage is gained through the use of
borrowing, repurchase agreements (repos), and derivatives. It is not
unusual to put on an FIA trade for a $100 million notional amount
requiring less than $1 million of posted collateral. Usually, the more
basic types of FIA trades use higher levels of leverage than do more
complicated trades (such as mortgage-backed security trades) that
expose positions to particular risks.

FIA returns are made up of spread profits, due to systematic risk

premia and/or price inefficiencies, and carry, which is the excess of
positive cash flow over negative cash flow. A simple example of carry
would be a long position that earned 5.25% interest paired to a short
position paying out 5.05%; a 20 basis point carry profit can be
achieved by this spread.

Returns from FIA trades can result from sudden market dislocations,
demand

or

supply

shocks,

changes

in

investor

preferences,

restrictions on particular instruments or markets, credit rating

changes, execution of options embedded within debt securities, and
any event that changes a bonds anticipated cash flow. Price
inefficiencies can arise from a number of factors:
1)

Agency bias: the tendency of fiduciaries to purchase

securities based on past results

52

2)

Structural impediments: the trading of securities for non-

economic reasons relating to tax, regulatory,

and accounting

issues
3)

Market segmentation: the preference for a particular range

of maturities can become pronounced enough to cause price

dislocations between different securities

Systematic risk premia can result from several causes. For instance, a
hedged spread may feature long and short positions that differ in
liquidity or credit quality. In this case, a premium is earned by holding
lower quality or less liquid positions and shorting higher quality/more
liquid positions.

Other systematic risks can arise from, among others,

cross-currency trades, and spreads between Treasury and agency debt.

In general, FIA traders earn their premia by taking positions that profit
when the sky doesnt fall. This is similar to selling a disaster put the
buyer would profit only in the case of catastrophe, in which case the buyer
can put securities to the seller at a pre-catastrophe price. This is a form of
insurance; you might recall credit default swaps, which served a similar
purpose. Normally, it works, and the put seller pockets the puts premium
when it expires without intervening economic disaster.
FIA trades behave much like the short put strategy. When turmoil occurs,
there is a flight to quality that causes bond spreads to widen and liquidity to
dry up, all of which cause FIA traders to realize losses. As a crisis unfolds,
market participants all exit at the same time, and leveraged positions
collapse. Bankruptcy and financial ruin can easily follow. The collapse of
Long Term Capital Management in 1999 is a famous object lesson in this
regard.
Equity

market

neutral:

exploits

differences

in

stock

prices

by

being long and short in stocks within the same sector, industry, market

53

capitalization, country, which also creates a hedge against broader market

factors.
Convertible arbitrage: It exploits pricing inefficiencies between convertible
securities and the corresponding stocks. This strategy primarily involves
taking long positions in convertible bonds or warrants, hedged with a short
position, typically in the underlying stock. Convertible bonds and warrants
(as derivatives) are priced as a function of the price of the underlying stock,
expected future volatility of returns, risk-free interest rates and the issuerspecific corporate Treasury yield spread.

However, in many cases,

convertible bonds and warrants are not accurately priced due to illiquidity
in the convertible debt and warrant markets as compared to the markets in
the underlying common stocks, uncertainty concerning the call or
redemption features of convertible securities and lesser market focus on
these derivatives as opposed to the equities into which they are convertible
or exercisable.

These mispricings may give rise to significant profit

opportunities, as positions are acquired in anticipation of the market price

eventually reflecting true value.
Delta

hedging is

the

process

of

setting

or

keeping

the delta of

a portfolio of financial instruments zero, or as close to zero as possible where delta is the sensitivity of the value of a derivative to changes in the
price of its underlying instrument; see Hedge (finance). Mathematically,
delta is the partial derivative of the portfolio's fair value with respect to the
price of the underlying security; Being delta neutral (or, instantaneously
delta-hedged) means that the instantaneous change in value of the portfolio
for an infinitesimal change in the value of the underlying is zero.
As with most successful arbitrage strategies, convertible arbitrage has
attracted

large

number

of

market

participants,

creating

intense

competition and reducing the effectiveness of the strategy. For example,

many convertible arbitrageurs suffered losses in early 2005 when the credit
of General Motors was downgraded at the same time Kirk Kerkorian was
making an offer for GM's stock. Since most arbitrageurs were long GM debt

54

and short the equity, they were hurt on both sides. Going back a lot further,
many such "arbs" sustained big losses in the so-called "crash of '87". In
theory, when a stock declines, the associated convertible bond will decline
less, because it is protected by its value as a fixed-income instrument: it
pays interest periodically. In the 1987 stock market crash, however, many
convertible bonds declined more than the stocks into which they were
convertible, apparently for liquidity reasons (the market for the stocks being
much more liquid than the relatively small market for the bonds).
Arbitrageurs who relied on the traditional relationship between stock and
bond gained less from their short stock positions than they lost on their long
bond positions.

Asset-backed

securities

(Fixed-Income

asset-backed): fixed

income

arbitrage strategy using asset-backed securities.

Credit long / short: the same as long / short equity but in credit
markets instead of equity markets.

Statistical arbitrage: identifying pricing inefficiencies between securities

through mathematical modeling techniques

Volatility arbitrage: exploit the change in implied volatility instead of the

change in price.

Yield alternatives: non-fixed income arbitrage strategies based on the

yield instead of the price.

Regulatory arbitrage: the practice of taking advantage of regulatory

differences between two or more markets.

Risk arbitrage: exploiting market discrepancies between acquisition price

and stock price

55

Risk Return relationship with Hedge Fund :

One of the most interesting issues related to Hedge fund is the risk return
relationship of the fund. So a discussion from the practical point of view is
of importance so that proper benchmarking is possible with the fund
performance .
Hedge fund investment strategies tend to be quite different from the
strategies followed by traditional money managers. In principle every fund
follows its own proprietary strategy, which means that hedge funds are an
extremely heterogeneous group. It is common practice, however, to classify
hedge funds depending on the main type of strategy that funds claim to
follow and the different strategies have already been discussed in the
previous parts of this study material.
Given the above classification, the question arises whether funds classified
as following the same type of strategy indeed generate similar returns. We
can easily investigate this by calculating the correlation between the returns
of funds within each strategy group. Actual data shows the average
correlations between individual hedge funds belonging to the same strategy
group are quite low. This makes it clear that although funds may be
classified in the same strategy group, this does in no way mean that they
will produce similar returns. The correlation coefficients between funds
belonging to different strategy groups are low as well. The fact that the
average correlation between funds of the same type and between different
types of funds is of a similar order of magnitude is an interesting finding. It
suggests that it may not make too much difference whether an investor
diversifies within a given strategy group or between strategy groups.
The true risk of hedge funds tend to be seriously underestimated
Marking-to-market problems tend to create lags in the evolution of hedge
funds netasset values, which statistically shows up as autocorrelation in

56

hedge funds returns. This autocorrelation causes estimates of the standard

deviation of hedge fund returns to exhibit a systematic downward bias.
The results show that the problem is especially acute for convertible
arbitrage and distressed securities funds, which makes sense as these
funds assets will typically be the most difficult to value.
A second reason why many investors think hedge funds are less risky than
they really are results from the use of the standard deviation as the sole
measure of risk. Generally speaking, risk is one word, but not one number.
The returns on portfolios of stocks and bonds risk are more or less normally
distributed. Because normal distributions are fully described by their mean
and standard deviation, the risk of such portfolios can indeed be measured
with one number. Confronted with non-normal distributions, however, it is
no longer appropriate to use the standard deviation as the sole measure of
risk. In that case investors should also look at the degree of symmetry
of the distribution, as measured by its so-called skewness, and the
probability of extreme positive or negative outcomes, as measured by the
distributions kurtosis. A symmetrical distribution will have a skewness
equal to zero, while a distribution that implies a relatively high
probability of a large loss (gain) is said to exhibit negative (positive)
skewness. A normal distribution has a kurtosis of 3, while a kurtosis
higher than 3 indicates a relatively high probability of a large loss or
gain. Since most investors are in it for the longer run, they strongly rely on
compounding effects. This means that negative skewness and high kurtosis
are extremely undesirable features as one big loss may destroy years of
careful compounding shows the average skewness and kurtosis found in the
returns of individual hedge funds from various strategy groups. From the
actual data , it is clear that hedge fund returns tend to be far from normally
distributed and exhibit significant negative skewness as well as substantial
kurtosis. Put another way, hedge fund returns may exhibit relatively low
standard deviations but they also tend to provide skewness and kurtosis
attributes that are exactly opposite to what investors desire. It is this whole
package that constitutes hedge fund risk, not just the standard deviation.

57

Sharp Ratio and Alpha of hedge fund is highly misleading :

To evaluate hedge fund performance many investors use the so-called
Sharpe ratio, which is calculated as the ratio of the average excess return
and the return standard deviation of the fund being evaluated. When
applied to raw hedge fund return data, the relatively high means and low
standard deviations offered by hedge funds lead to Sharpe ratios that are
considerably higher than those of the relevant benchmark indices.
Whilst this type of analysis is widely used, it is again not without problems.
First, survivorship bias and autocorrelation will cause investors to
overestimate the mean and underestimate the standard deviation. Second,
the Sharpe ratio does not take account of the negative skewness and excess
kurtosis observed in hedge fund returns. This means that the Sharpe ratio
will tend to systematically overstate true hedge fund performance.
In this context it is important to note that there tends to be a clear
relationship between a funds Sharpe ratio and the skewness and kurtosis of
that funds return distribution.
High Sharpe ratios tend to go together with negative skewness and high
kurtosis. This means that the relatively high mean and low standard
deviation offered by hedge funds is not coming free. Investors simply pay for
a more attractive Sharpe ratio in the form of more negative skewness and
higher kurtosis.
Another performance measure often used is alpha. The idea behind alpha is
to first construct a portfolio that replicates the sensitivities of a fund to the
relevant return generating factors and then compare the fund return with
the return on that portfolio.
If the fund produces a higher average return, this can be interpreted as
superior performance since both share the same return generating factors.
The main problem with this approach lies in the choice of return generating
factors. We have little idea what factors really generate hedge fund returns.
As a result, investors that calculate hedge funds alphas are likely to leave

58

out one or more relevant risk factors. This will produce excess return where
in reality there is none.
Good examples of often forgotten but extremely important risks are credit
and liquidity risk. So far, no study of hedge fund performance has explicitly
figured in credit or liquidity risk as a source of return, despite the fact that
some hedge funds virtually live off it.
Providing liquidity to a market, can be expected to be compensated by a
higher average return. However, when this is not taken into account, we will
find alpha where there is in fact none.
The above makes it very clear that when it comes to hedge funds, traditional
performance evaluation methods like the Sharpe ratio and alpha can be
extremely misleading. A high Sharpe ratio or alpha should therefore not be
interpreted as an indication of superior manager skill, but first and foremost
as an indication that further research is required. One can only speak of
superior performance if such research shows that the manager in question
generates the observed excess return without taking any unusual and/or
catastrophic risks. Unfortunately, simply studying a managers past returns
will not be enough. Apart from the fact that most hedge fund managers do
not have much of a track record to study, extreme events only occur
infrequently so that it is hard if not impossible to identify the presence of
catastrophic risk from a relatively small sample of returns. Consider the
following example. A substantial portion of the outstanding supply of
catastrophe-linked bonds are held by hedge funds. These bonds pay an
exceptionally high coupon in return for the bondholder putting (part of) his
principal at risk. Since the world has not seen a major catastrophe for some
time now, these bonds have performed very well and the available return
series show little skewness. However, this does not give an accurate
indication of the actual degree of skewness as when a catastrophe does
eventually occur, these bonds will produce very large losses.
Investment Ideas of Investment Gurus :

59

Benjamin Graham : Graham was an investor and investing mentor who is

generally considered to be the father of security analysis and value
investing. His ideas and methods on investing are well documented in his
books Security Analysis (1934) and The Intelligent Investor (1949), which
are two of the most famous investing books. These texts are often considered
to be requisite reading material for any investor, but they arent easy reads.
Here, well condense Grahams main investing principles and give you a
head start on understanding his winning philosophy.
Principle No. 1: Always Invest With a Margin of Safety
Margin of safety is the principle of buying a security at a significant discount
to its intrinsic value, which is thought to not only provide high-return
opportunities but also to minimize the downside risk of an investment. In
simple terms, Grahams goal was to buy assets worth Rs 100 for Rs 50/To Graham, these business assets may have been valuable because of their
stable earning power or simply because of their liquid cash value. It wasnt
uncommon, for example, for Graham to invest in stocks in which the liquid
assets on the balance sheet (net of all debt) were worth more than the total
market cap of the company (also known as net nets to Graham followers).
This means that Graham was effectively buying businesses for nothing. This
concept is very important for investors to note, as value investing can
provide substantial profits once the market inevitably re-evaluates the stock
and raises its price to fair value. It also provides protection on the downside
if things dont work out as planned and the business falters. The safety net
of buying an underlying business for much less than it is worth was the
central theme of Grahams success. When stocks are chosen carefully,
Graham found that a further decline in these undervalued equities occurred
infrequently.
While many of Grahams students succeeded using their own strategies,
they all shared the main idea of the margin of safety.
Principle No. 2: Expect Volatility and Profit From It:

60

Investing in stocks means dealing with volatility. Instead of running for the
exits during times of market stress, the smart investor greets downturns as
chances to find great investments. Graham illustrated this with the analogy
of Mr. Market, the imaginary business partner of each and every investor.
Mr. Market offers investors a daily price quote at which he would either buy
an investor out or sell his share of the business. Sometimes, he will be
excited about the prospects for the business and quote a high price. Other
times, he will be depressed about the businesss prospects and will quote a
low price.
Because the stock market has these same emotions, the lesson here is that
you shouldnt let Mr. Markets views dictate your own emotions or, worse,
lead you in your investment decisions. Instead, you should form your own
estimates of the businesss value based on a sound and rational
examination of the facts. Furthermore, you should only buy when the price
offered makes sense and sell when the price becomes too high. Put another
way, the marketwill fluctuatesometimes wildlybut rather than fearing
volatility, use it to your advantage to get bargains in the market or to sell
out when your holdings become way overvalued.
Here are two strategies that Graham suggested to help mitigate the negative
effects of market volatility:
Dollar-cost averaging: Achieved by buying equal dollar amounts of
investments at regular intervals. It takes advantage of dips in the price and
means that an investor doesnt have to be concerned about buying his or
her entire position at the top of the market. Dollar-cost averaging is ideal for
passive investors and alleviates them of the responsibility of choosing when
and at what price to buy their positions.
Investing in stocks and bonds: Graham recommended distributing ones
portfolio evenly between stocks and bonds as a way to preserve capital in
market downturns while still achieving growth of capital through bond
income. Remember, Grahams philosophy was, first and foremost, to

61

preserve capital, and then to try to make it grow. He suggested having 25%
to 75% of your investments in bonds, and varying this based on market
conditions. This strategy had the added advantage of keeping investors from
boredom, which leads to the temptation to participate in unprofitable
trading (i.e., speculating).
Principle No. 3: Know What Kind of Investor You Are
Graham said investors should know their investment selves. To illustrate
this, he made clear distinctions among various groups operating in the stock
market.
Active

vs.

passive: Graham

referred

to active and passive

investors as

enterprising investors and defensive investors.

You only have two real choices: The first is to make a serious commitment in
time and energy to become a good investor who equates the quality and
amount of hands-on research with the expected return. If this isnt your cup
of tea, then be content to get a passive, and possibly lower, return but with
much less time and work. Graham turned the academic notion of risk =
return on its head. For him, work = return. The more work you put into
your investments, the higher your return should be.
If you have neither the time nor the inclination to do quality research on
your investments, then investing in an index is a good alternative. Graham
said that the defensive investor could get an average return by simply
buying the 30 stocks of the Dow Jones industrial average in equal amounts.
Both Graham and Buffett said getting even an average returnfor example,
equalling the return of the S&P 500is more of an accomplishment than it
might seem.
The fallacy that many people buy into, according to Graham, is that if its so
easy to get an average return with little or no work (through indexing), then
just a little more work should yield a slightly higher return. The reality is
that most people who try this end up doing much worse than average.

62

In modern terms, the defensive investor would be an investor in index funds

of both stocks and bonds. In essence, they own the entire market, benefiting
from the areas that perform the best without trying to predict those areas
ahead of time. In doing so, an investor is virtually guaranteed the markets
return and avoids doing worse than average by just letting the stock
markets overall results dictate long-term returns. According to Graham,
beating the market is much easier said than done, and many investors still
find they dont beat the market.
Speculator vs. investor: Not all people in the stock market are investors.
Graham believed that it was critical for people to determine whether they
were investors or speculators. The difference is simple: An investor looks at
a stock as part of a business and the stockholder as the owner of the
business, while the speculator views himself as playing with expensive
pieces of paper with no intrinsic value. For the speculator, value is only
determined by what someone will pay for the asset. To paraphrase Graham,
there is intelligent speculating as well as intelligent investingjust be sure
you understand which you are good at.
Buffett's Philosophy
Warren

Buffett

investing.

Value

descends
investors

from
look

the Benjamin
for

securities

Graham school
with

prices

of value
that are

unjustifiably low based on their intrinsic worth. When discussing stocks,

determining intrinsic value can be a bit tricky as there is no universally
accepted way to obtain this figure. Most often intrinsic worth is estimated by
analyzing a company's fundamentals. Like bargain hunters, value investors
seek products that are beneficial and of high quality but underpriced. In
other words, the value investor searches for stocks that he or she believes
are undervalued by the market. Like the bargain hunter, the value investor
tries to find those items that are valuable but not recognized as such by the
majority of other buyers.

63

Warren Buffett takes this value investing approach to another level. Many
value investors aren't supporters of the efficient market hypothesis, but they
do trust that the market will eventually start to favor those quality stocks
that were, for a time, undervalued. Buffett, however, doesn't think in these
terms. He isn't concerned with the supply and demand intricacies of the
stock market. In fact, he's not really concerned with the activities of the
stock market at all. This is the implication this paraphrase of his famous
quote : "In the short term the market is a popularity contest; in the long
term it is a weighing machine

He chooses stocks solely on the basis of their overall potential as a company

- he looks at each as a whole. Holding these stocks as a long-term play,
Buffett seeks not capital gain but ownership in quality companies extremely
capable of generating earnings. When Buffett invests in a company, he isn't
concerned with whether the market will eventually recognize its worth; he is
concerned with how well that company can make money as a business.
Buffett's Methodology

Here we look at how Buffett finds low-priced value by asking himself some
questions when he evaluates the relationship between a stock's level of
excellence and its price. Keep in mind that these are not the only things he
analyzes but rather a brief summary of what Buffett looks for:

1. Has the company consistently performed well?

Sometimes return on equity (ROE) is referred to as "stockholder's return on

investment". It reveals the rate at which shareholders are earning income on
their shares. Buffett always looks at ROE to see whether or not a company

64

has consistently performed well in comparison to other companies in the

same industry. ROE is calculated as follows:

= Net Income / Shareholder\'s Equity

Looking at the ROE in just the last year isn't enough. The investor should
view the ROE from the past five to 10 years to get a good idea of historical
performance.

2.

Has

The debt/equity

the

company

ratio is

another

avoided
key

characteristic

excess
Buffett

debt?
considers

carefully. Buffett prefers to see a small amount of debt so that earnings

growth is being generated from shareholders' equity as opposed to borrowed
money. The debt/equity ratio is calculated as follows:
= Total Liabilities / Shareholders\' Equity

This ratio shows the proportion of equity and debt the company is using to
finance its assets, and the higher the ratio, the more debt - rather than
equity - is financing the company. A high level of debt compared to equity
can result in volatile earnings and large interest expenses. For a more
stringent test, investors sometimes use only long-term debt instead of
total liabilities in the calculation above.

3. Are profit margins high? Are they increasing?

The profitability of a company depends not only on having a good profit
margin but also on consistently increasing this profit margin. This margin is
calculated by dividing net income by net sales. To get a good indication of

65

historical profit margins, investors should look back at least five years. A
high profit margin indicates the company is executing its business well, but
increasing margins means management has been extremely efficient and
successful at controlling expenses.

4. How long has the company been public?

Buffett typically considers only companies that have been around for at least
10 years. As a result, most of the technology companies that have had
their initial public offerings (IPOs) in the past decade wouldn't get on
Buffett's radar (not to mention the fact that Buffett will invest only in a
business that he fully understands, and he admittedly does not understand
what a lot of today's technology companies actually do). It makes sense that
one of Buffet's criteria is longevity: value investing means looking at
companies that have stood the test of time but are currently undervalued.
Never

underestimate

the

value

of

historical

performance,

which

demonstrates the company's ability (or inability) to increase shareholder

value. Do keep in mind, however, that the past performance of a stock does
not guarantee future performance - the job of the value investor is to
determine how well the company can perform as well as it did in the past.
Determining this is inherently tricky, but evidently Buffett is very good at it.
5. Do the company's products rely on a commodity?
Initially you might think of this question as a radical approach to narrowing
down a company. Buffett, however, sees this question as an important one.
He tends to shy away (but not always) from companies whose products are
indistinguishable from those of competitors, and those that rely solely on
a commodity such as oil and gas. If the company does not offer anything
different than another firm within the same industry, Buffett sees little that
sets the company apart. Any characteristic that is hard to replicate is what

66

Buffett calls a company's economic moat, or competitive advantage. The

wider the moat, the tougher it is for a competitor to gain market share.
6. Is the stock selling at a 25% discount to its real value?
This is the kicker. Finding companies that meet the other five criteria is one
thing, but determining whether they are undervalued is the most difficult
part of value investing, and Buffett's most important skill. To check this, an
investor must determine the intrinsic value of a company by analyzing a
number of business fundamentals, including earnings, revenues and assets.
And a company's intrinsic value is usually higher (and more complicated)
than its liquidation value - what a company would be worth if it were broken
up and sold today. The liquidation value doesn't include intangibles such as
the value of a brand name, which is not directly stated on the financial
statements.
Once Buffett determines the intrinsic value of the company as a whole, he
compares it to its current market capitalization - the current total worth
(price). If his measurement of intrinsic value is at least 25% higher than the
company's market capitalization, Buffett sees the company as one that has
value. Sounds easy, doesn't it? Well, Buffett's success, however, depends on
his unmatched skill in accurately determining this intrinsic value. While we
can outline some of his criteria, we have no way of knowing exactly how he
gained such precise mastery of calculating value.

George Soros' Philosophy:

George Soros is a short-term speculator. He makes massive, highlyleveraged bets on the direction of the financial markets. His famous hedge
fund is known for its global macro strategy, a philosophy centered around
making massive, one-way bets on the movements of currency rates,

67

commodity prices, stocks, bonds, derivatives and other assets based on

macroeconomic analysis.

Simply put, Soros bets that the value of these investments will either rise or
fall. This is "seat of the pants" trading, based on research and executed on
instinct. Soros studies his targets, letting the movements of the various
financial markets and their participants dictate his trades. He refers to the
philosophy behind his trading strategy as reflexivity. The theory eschews
traditional ideas of an equilibrium-based market environment where all
information is known to all market participants and thereby factored into
prices. Instead, Soros believes that market participants themselves directly
influence market fundamentals, and that their irrational behavior leads to
booms and busts that present investment opportunities.

Housing prices provide an interesting example of his theory in action. When

lenders make it easy to get loans, more people borrow money. With money in
hand, these people buy homes, which results in a rise in demand for homes.
Rising demand results in rising prices. Higher prices encourage lenders to
lend more money. More money in the hands of borrowers results in rising
demand for homes, and an upward spiralling cycle that results in housing
prices that have been bid up way past where economic fundamentals would
suggest is reasonable. The actions of the lenders and buyers have had a
direct influence on the price of the commodity.

An investment based on the idea that the housing market will crash would
reflect a classic Soros bet. Short-selling the shares of luxury home builders
or shorting the shares of major housing lenders would be two potential
investments

seeking

to

profit

when

Major Trades

68

the housing

boom

goes

bust.

George Soros will always be remembered as "the man who broke the Bank of
England." A well-known currency speculator, Soros does not limit his efforts
to a particular geographic area, instead considering the entire world when
seeking opportunities. In September of 1992, he borrowed billions of dollars
worth of British pounds and converted them to German marks.
When the pound crashed, Soros repaid his lenders based on the new, lower
value of the pound, pocketing in excess of $1 billion in the difference
between the value of the pound and the value of the mark during a single
day's trading. He made nearly $2 billion in total after unwinding his
position.
He made a similar move with Asian currencies during the 1997 Asian
Financial Crisis, participating in a speculative frenzy that resulted in the
collapse of the baht (Thailand's currency). These trades were so effective
because the national currencies the speculators bet against were pegged to
other currencies, meaning that agreements were in place to "prop up" the
currencies in order to make sure that they traded in a specific ratio against
the currency to which they were pegged.

When the speculators placed their bets, the currency issuers were forced to
attempt to maintain the ratios by buying their currencies on the open
market. When the governments ran out of money and were forced to
abandon that effort, the currency values plummeted.
Governments lived in fear that Soros would take an interest in their
currencies. When he did, other speculators joined the fray in what's been
described as a pack of wolves descending on a herd of elk. The massive
amounts of money the speculators could borrow and leverage made it
impossible for the governments to withstand the assault.

69

Despite his masterful successes, not every bet George Soros made worked in
his favor. In 1987, he predicted that the U.S. markets would continue to
rise. His fund lost $300 million during the crash, although it still delivered
low double-digit returns for the year.

He also took a $2 billion hit during the Russian debt crisis in 1998 and lost
$700 million in 1999 during the tech bubble when he bet on a decline.
Stung by the loss, he bought big in anticipation of a rise. He lost nearly $3
billion when the market finally crashed.
His public stance and spectacular success put Soros largely in a class by
himself. Over the course of more than three decades, he made the right
moves nearly every time, generating legions of fans among traders and
investors, and legions of detractors among those on the losing end of his
speculative activities.

70

Part A
MCQ
1. If an economy is moving from developing economy to developed
economy, the scope of Alternate Investment Management would :
a. Go up due to higher risk in the economy associated with the
developed economy
b. Go up due to higher risk taking capability of more High Networth Individual created out of higher economic growth
c. Go down due to higher regulations by regulators
d. Both a and c
2. Alternative Investment Management is ................... than normal
investment

and

accordingly

common

peoples

money

should

..................................... this investment class:

a. Safer ; flow into
b. Riskier ; not go to
c. Safer ; not go to
d. Riskier; flow into
3. In India hedge fund belongs to

.................................. Alternate

Investment Management class :

a. Category I
b. Category II
c. Category III
d. None of the above
4. Alternate Investment Fund would invest preferably in to :
a. Listed Debt
b. Listed Equity
c. Unlisted Equity
d. Unlisted Debt
5. Hedge fund works on ........................ ............................... strategy
a. High Risk ; High Return
b. Low Risk ; Low Return

71

c. High Risk ; Low Return

d. Low Risk; High Return
6. If the age of an Investor is 30 and the investment surplus is Rs 10000
/- , then the investment in equity as per Benjamin Graham would be :
a. Rs 7000/b. Rs 4000/c. Rs 3000/d. None of the above
7. Which of the following stock would be taken in the portfolio as per
Warren Buffet Strategy :
a) Tata Steel
b) Tata Motors
c) Flipcart
d) Both a and b
8. Mark to Market valuation would be .................. frequent for
investment of Alternate Fund in India :
a. Category III
b. Category II
c. Category I
d. Both a and c
9. Which of the following should not be an investor in an Alternate
Investment Fund ?
a. Investment Bank
b. Commercial Banks
c. Insurance companies
d. Both b and c
10.

Which of the following should not be a performance measure of

Alternate Investment Fund ?

a. CAPM
b. APT
c. Both a and b
d. None of the above

72


Short Questions
1. As a Chief Financial Officer of a SME company, at what stage would
you approach an Alternate Investment Management firm . Please give
reason for your answers .
Alternate investment management is a source of fund which can take
high risk and high return. So when an SME is in the growth phase
and it requires more fund , it may approach a bank for the funding .
The bank may insist that the SME should bring in more equity. Since
there is a limit up to which promoter can bring in the equity , the
company can approach the Alternate Investment Fund for equity
infusion. The risk of the investment is higher but at the same time
the return is also higher. Since investor of this fund belongs to High
Net Worth Individual , the

higher riskiness matches with the risk

profile of the investor. Now once the SME grows to higher end or mid
corporate , the riskiness of the borrower would come down and then
the firm can be listed in the market and accordingly retail investor
would be able to participate. So as a CFO , you would approach the
AIM when the SME is into the growth phase and you think that listing
in the main exchange is about three to four years away .
2. State three differences between Category I and Category III fund as
prescribed in the SEBI AIM guidelines ;
Investment Objectives : The investment objective Category I is to
provide equity to the growth oriented sector like SME , Infrastructure ,
Social Sector. Where as the investment objectives of Category III fund
is to make profit from speculative activities
Use of Leverage : There should not be use of leverage by Category I
fund as it increases the risk of the fund . There should be use of
leverage by Category III find as its main aim is to generate higher
return from higher risk category

73

Valuation Norms : The Valuation norms for Category I fund is relaxed.

More Category I fund, the valuation norms is half yearly where as the
valuation norms for Category III fund is quarterly. This is due to the
fact that investment in Category III fund is mainly in traded securities
where Mark To Market valuation is possible.
3. Why traditional risk return matrix would not evaluate Hedge Fund
Performance ?
From the actual data , it is clear that hedge fund returns tend to be far from
normally distributed and also it exhibits significant negative skewness as
well as substantial kurtosis. Hedge fund returns may exhibit relatively low
standard deviations but they also tend to provide skewness and kurtosis
attributes that are exactly opposite to what investors desire. Accordingly
traditional measures like Sharpe ratio does not take account of the negative
skewness and excess kurtosis observed in hedge fund returns. This means
that the Sharpe ratio will tend to systematically overstate true hedge fund
performance.
4. What are the advantages and disadvantages of Geroge Soros
Investment philosophy ?
George Soros investment strategy has speculative component. Under this
strategy, the investor would speculate about the price of

the targeted

security. While speculating the investor would take the help of supports
available and the investor would take a call on the directional movement in
the price of the security. If the prediction turns out to be correct, the
investor would make large profit. In case it does not make the correct
prediction , it would incur the loss. In case of this investment strategy, the
investor can incur loss some times and some times he can make profit. So
this strategy of investment is riskier and the investor should have higher Net
Worth to pursue this strategy .
5. If REIT is coming under Alternate Investment Fund ? What are the
differences between REIT and Real Estate Investment Fund ?

74

REIT is not coming under Alternate Investment Fund . REIT is governed by a

separate regulations . SEBI has made the investment in REIT is much easier
with the minimum investment amount is made Rs 2 lacs. Besides the REIT
has got lot of restriction from the investment side where as the Real Estate
Investment Fund under AIM has lot of flexibility for investment . So Real
Estate Investment Trust is less riskier investment compared to Real Estate
Investment fund under AIM. Riskier real estate project would be funded by
the Real Estate Investment Fund under AIM whereas the less riskier real
estate project would be funded by REIT.

75

Case Study on Hedge Fund Failure : Long Term Capital Management (

LTCM ) Case :

Taken from Sungard, Bancware Erisk. Link to Sungard. Spring 2006.

Summary

In 1994, John Meriwether, the famed Salomon Brothers bond trader,

founded a hedge fund called Long-Term Capital Management. Meriwether
assembled an all-star team of traders and academics in an attempt to create
a fund that would profit from the combination of the academics' quantitative
models and the traders' market judgement and execution capabilities.
Sophisticated investors, including many large investment banks, flocked to
the fund, investing $1.3 billion at inception. But four years later, at the end
of September 1998, the fund had lost substantial amounts of the investors'
equity capital and was teetering on the brink of default. To avoid the threat
of a systemic crisis in the world financial system, the Federal Reserve
orchestrated a $3.5 billion rescue package from leading U.S. investment and
commercial banks. In exchange the participants received 90% of LTCM's
equity.
The lessons to be learned from this crisis are:

Market values matter for leveraged portfolios;

Liquidity itself is a risk factor;

Models must be stress-tested and combined with judgement; and

Financial institutions should aggregate exposures to common risk

factors.

76

Overview

LTCM seemed destined for success. After all, it had John Meriwether, the
famed bond trader from Salomon Brothers, at its helm. Also on board were
Nobel-prize winning economists Myron Scholes and Robert Merton, as well
as David Mullins, a former vice-chairman of the Federal Reserve Board who
had quit his job to become a partner at LTCM. These credentials convinced
80 founding investors to pony up the minimum investment of $10 million
apiece, including Bear Sterns President James Cayne and his deputy.
Merrill Lynch purchased a significant share to sell to its wealthy clients,
including a number of its executives and its own CEO, David Komansky. A
similar strategy was employed by the Union Bank of Switzerland (The
Washington Post, 9/27/98).

LTCM's main strategy was to make convergence trades. These trades

involved finding securities that were mispriced relative to one another,
taking long positions in the cheap ones and short positions in the rich ones.
There were four main types of trade:

Convergence among U.S., Japan, and European sovereign bonds;

Convergence among European sovereign bonds;

Convergence between on-the-run and off-the-run U.S. government

bonds;

Long positions in emerging markets sovereigns, hedged back to

dollars.

Because these differences in values were tiny, the fund needed to take large
and highly-leveraged positions in order to make a significant profit. At the
beginning of 1998, the fund had equity of $5 billion and had borrowed over
$125 billion a leverage factor of roughly thirty to one. LTCM's partners
believed, on the basis of their complex computer models, that the long and
short positions were highly correlated and so the net risk was small.

77

Events
1994: Long-Term Capital Management is founded by John Meriwether and
accepts investments from 80 investors who put up a minimum of $10
million each. The initial equity capitalisation of the firm is $1.3 billion. (The
Washington Post, 27 September 1998)

End of 1997: After two years of returns running close to 40%, the fund has
some $7 billion under management and is achieving only a 27% return
comparable

with

the

return

on

US

equities

that

year.

Meriwether returns about $2.7 billion of the fund's capital back to investors
because "investment opportunities were not large and attractive enough"
(The Washington Post, 27 September 1998).

Early 1998: The portfolio under LTCM's control amounts to well over $100
billion, while net asset value stands at some $4 billion; its swaps position is
valued at some $1.25 trillion notional, equal to 5% of the entire global
market. It had become a major supplier of index volatility to investment
banks, was active in mortgage-backed securities and was dabbling in
emerging

markets

such

as

Russia

(Risk,

October

1998)

17 August 1998: Russia devalues the rouble and declares a moratorium on

281 billion roubles ($13.5 billion) of its Treasury debt. The result is a
massive "flight to quality", with investors flooding out of any remotely risky
market and into the most secure instruments within the already "risk-free"
government bond market. Ultimately, this results in a liquidity crisis of
enormous

proportions,

dealing

severe

blow

to

LTCM's

portfolio.

1 September 1998: LTCM's equity has dropped to $2.3 billion. John

Meriwether circulates a letter which discloses the massive loss and offers
the chance to invest in the fund "on special terms". Existing investors are

78

told that they will not be allowed to withdraw more than 12% of their
investment, and not until December.

22 September 1998: LTCM's equity has dropped to $600 million. The

portfolio has not shrunk significantly, and so its leverage is even higher.
Banks begin to doubt the fund's ability to meet its margin calls but cannot
move to liquidate for fear that it will precipitate a crisis that will cause huge
losses among the fund's counterparties and potentially lead to a systemic
crisis.
23 September 98: Goldman Sachs, AIG and Warren Buffett offer to buy out
LTCM's partners for $250 million, to inject $4 billion into the ailing fund and
run it as part of Goldman's proprietary trading operation. The offer is not
accepted. That afternoon, the Federal Reserve Bank of New York, acting to
prevent a potential systemic meltdown, organises a rescue package under
which a consortium of leading investment and commercial banks, including
LTCM's major creditors, inject $3.5-billion into the fund and take over its
management, in exchange for 90% of LTCM's equity.

Fourth

quarter

1998:

The

damage

from

LTCM's

near-demise

was

widespread. Many banks take a substantial write-off as a result of losses on

their investments. UBS takes a third-quarter charge of $700 million,
Dresdner Bank AG a $145 million charge, and Credit Suisse $55 million.
Additionally, UBS chairman Mathis Cabiallavetta and three top executives
resign in the wake of the bank's losses (The Wall Street Journal Europe, 5
October 1998). Merrill Lynch's global head of risk and credit management
likewise leaves the firm.

79

April 1999: President Clinton publishes a study of the LTCM crisis and its
implications for systemic risk in financial markets, entitled the President's
Working Group on Financial Markets (Governance and Risk ControlRegulatory guidelines-president's working group)

Analysis:

The Proximate Cause: Russian Sovereign Default

The proximate cause for LTCM's debacle was Russia's default on its
government obligations (GKOs). LTCM believed it had somewhat hedged its
GKO position by selling rubles. In theory, if Russia defaulted on its bonds,
then the value of its currency would collapse and a profit could be made in
the foreign exchange market that would offset the loss on the bonds.
Unfortunately, the banks guaranteeing the ruble hedge shut down when the
Russian ruble collapsed, and the Russian government prevented further
trading in its currency. (The Financial Post, 9/26/98). While this caused
significant losses for LTCM, these losses were not even close to being large
enough to bring the hedge fund down. Rather, the ultimate cause of its
demise was the ensuing flight to liquidity described in the following section.
The Ultimate Cause: Flight to Liquidity

The ultimate cause of the LTCM debacle was the "flight to liquidity" across
the global fixed income markets. As Russia's troubles became deeper and
deeper, fixed-income portfolio managers began to shift their assets to more
liquid assets. In particular, many investors shifted their investments into
the U.S. Treasury market. In fact, so great was the panic that investors

80

moved money not just into Treasury, but into the most liquid part of the
U.S. Treasury market -- the most recently issued, or "on-the-run"
Treasuries. While the U.S. Treasury market is relatively liquid in normal
market conditions, this global flight to liquidity hit the on-the-run
Treasuries like a freight train. The spread between the yields on on-the-run
Treasuries and off-the-run Treasuries widened dramatically: even though
the off-the-run bonds were theoretically cheap relative to the on-the-run
bonds,

they

got

much

cheaper

still

(on

relative

basis).

What LTCM had failed to account for is that a substantial portion of its
balance sheet was exposed to a general change in the "price" of liquidity. If
liquidity became more valuable (as it did following the crisis) its short
positions would increase in price relative to its long positions. This was
essentially a massive, un-hedged exposure to a single risk factor.
As an aside, this situation was made worse by the fact that the size of the
new issuance of U.S. Treasury bonds has declined over the past several
years. This has effectively reduced the liquidity of the Treasury market,
making it more likely that a flight to liquidity could dislocate this market.
Systemic Risk: The Domino Effect
The preceding analysis explains why LTCM almost failed. However, it does
not explain why this near-failure should threaten the stability of the global
financial markets. The reason was that virtually all of the leveraged Treasury
bond investors had similar positions: Salomon Brothers, Merrill Lynch, the
III Fund (a fixed-income hedge fund that also failed as a result of the crisis)
and likely others.
There were two reasons for the lack of diversity of opinion in the market. The
first is that virtually all of the sophisticated models being run by the
leveraged players said the same thing: that off-the-run Treasuries were
significantly cheap compared with the on-the-run Treasuries. The second is
that many of the investment banks obtained order flow information through

81

their dealings with LTCM. They therefore would have known many of the
actual positions and would have taken up similar positions alongside their
client.
Indeed, one industry participant suggested that the Russian crisis was the
crowning blow on a domino effect that had started months before. In early
1998, Sandy Weill, as co-head of Citigroup, decided to shut down the
famous Salomon Brothers Treasury bond arbitrage desk. Salomon, one of
the largest players in the on-the-run/off-the-run trade, had to begin
liquidating its positions. As it did so, these trades became cheaper and
cheaper,

putting

pressure

on

all

of

the

other

leveraged

players.

Lessons to be learned:

Market values matter

LTCM was perhaps the biggest disaster of its kind, but it was not the first. It
had been preceded by a number of other cases of highly-leveraged
quantitative

firms

that

went

under

in

similar

circumstances.

One of the earliest was Franklin Savings and Loan, a hedge fund dressed
down as a savings & loan. Franklin's management had figured out that
many of the riskier pieces of mortgage derivatives were undervalued because
a) the market could not understand the risk on the risky pieces; and b) the
market overvalued those pieces with well-behaved accounting results.
Franklin decided it was willing to suffer volatile accounting results in
exchange for good economics.

More recently, the Granite funds, which specialised in mortgage-backed

securities trading, suffered as the result of similar trading strategies. The
funds took advantage of the fact that "toxic waste" (risky tranches) from the
mortgage derivatives market were good economic value. However, when the

82

Fed raised interest rates in February 1994, Wall Street firms rushed to
liquidate mortgage-backed securities, often at huge discounts.

Both of these firms claimed to have been hedged, but both went under when
they were "margin-called". In Franklin's case, the caller was the Office of
Thrift Supervision; in the Granite Fund's, the margin lenders. What is the
common theme among Franklin, the Granite Funds and LTCM? All three
depended on exploiting deviations in market value from fair value. And all
three depended on "patient capital" -- shareholders and lenders who
believed that what mattered was fair value and not market value. That is,
these fund managers convinced their stakeholders that because the fair
values were hedged, it didn't matter what happened to market values in the
short run they would converge to fair value over time. That was the
reason

for

the

"Long

Term"

part

of

LTCM's

name.

The problem with this logic is that capital is only as patient as its least
patient provider. The fact is that lenders generally lose their patience
precisely when the funds need them to keep it in times of market crisis.
As all three cases demonstrate, the lenders are the first to get nervous when
an external shock hits. At that point, they begin to ask the fund manager for
market valuations, not models-based fair valuations. This starts the fund
along the downward spiral: illiquid securities are marked-to-market; margin
calls are made; the illiquid securities must be sold; more margin calls are
made, and so on. In general, shareholders may provide patient capital; but
debt-holders do not.
The lesson learned from these case studies spoils some of the supposed "free
lunch" features of taking liquidity risk. These plays can indeed generate
excellent risk-adjusted returns, but only

if

held for

long

time.

Unfortunately the only real source of capital that is patient enough to take
fluctuations in market values, especially through crises, is equity capital.

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In other words, you can take liquidity bets, but you cannot leverage them
much.
Liquidity risk is itself a factor :
As pointed out in the analysis section of this article, LTCM fell victim to a
flight to liquidity. This phenomenon is common enough in capital markets
crises that it should be built into risk models, either by introducing a new
risk factor liquidity or by including a flight to liquidity in the stress
testing (see the following section for more detail on this). This could be
accomplished crudely by classifying securities as either liquid or illiquid.
Liquid securities are assigned a positive exposure to the liquidity factor;
illiquid securities are assigned a negative exposure to the liquidity factor.
The size of the factor movement (measured in terms of the movement of the
spread between liquid and illiquid securities) can be estimated either
statistically or heuristically (perhaps using the LTCM crisis as a "worst case"
scenario).
Using this approach, LTCM might have classified most of its long positions
as illiquid and most of its short positions as liquid, thus having a notional
exposure to the liquidity factor equal to twice its total balance sheet. A more
refined model would account for a spectrum of possible liquidity across
securities; at a minimum, however, the general concept of exposure to a
liquidity risk factor should be incorporated in to any leveraged portfolio.
Models must be stress-tested and combined with judgement:
Another key lesson to be learnt from the LTCM debacle is that even (or
especially) the most sophisticated financial models are subject to model risk
and parameter risk, and should therefore be stress-tested and tempered
with judgement. While we are clearly privileged in exercising 20/20
hindsight, we can nonetheless think through the way in which judgement
and stress-testing could have been used to mitigate, if not avoid, this
disaster.

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According to the complex mathematical models used by LTCM, the positions

were low risk. Judgement tells us that the key assumption that the models
depended on was the high correlation between the long and short positions.
Certainly, recent history suggested that correlations between corporate
bonds of different credit quality would move together (a correlation of
between 90-95% over a 2-year horizon). During LTCM's crisis, however, this
correlation dropped to 80%. Stress-testing against this lower correlation
might have led LTCM to assume less leverage in taking this bet.
However, if LTCM had thought to stress test this correlation, given that it
was such an important assumption, it would not even have had to make up
a stress scenario. This correlation had dropped to 75% as recently as 1992
(Jorion, 1999). Simply including this stress scenario in the risk management
of the fund might have led LTCM to assume less leverage in taking this bet.
Financial institutions must aggregate exposures to common risk factors :

One of the other lessons to be learned by other financial institutions is that

it is important to aggregate risk exposures across businesses. Many of the
large dealer banks exposed to a Russian crisis across many different
businesses only became aware of the commonality of these exposures after
the LTCM crisis. For example, these banks owned Russian GKOs on their
arbitrage desks, made commercial loans to Russian corporates in their
lending businesses, and had indirect exposure to a Russian crisis through
their prime brokerage lending to LTCM. A systematic risk management
process should have discovered these common linkages ex ante and
reported or reduced the risk concentration.

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