Academic turned fund manager, Dr Vinay Nair, founder and chief executive officer of Ada Investments believes that in terms of hedge funds, India is currently similar to the US in the 1980s. "It's a very young market, ripe with inefficiencies and mispricing making it very appealing to alternative or hedge fund strategies."
For potential managers of a first wave of Indian focused hedge funds, Nair believes that the country's investment markets have a lot to offer. "It's always easier to go to markets where you have tailwind and there aren't that many that have positive real growth at the moment" he says.
In his 2013 commentary, Nair emphasises that India is prone to disconnects, the traditional feeding ground of the hedge fund manager. In his commentary, Nair writes: "Since the impact of the global risk environment is magnified through feedback cycles, the effects are often exaggerated in India."
The result of all that exaggeration is dramatic gains in the Indian markets when the risk environment improves. Another reason for dramatic reversals lies in the micro-economic environment which continues to be strong as exports contribute to only one fifth of the GDP. "This can sometimes lead to a disconnect between the micro and the macro investors potentially explaining why the domestic equity markets have rallied over 20% this past year even as the currency has weakened. This disconnect between the currency and the equity market only highlights how headline grabbing macro-economic trends sometimes keep some powerful micro-economic trends below the global investor's radar" Nair writes.
In terms of the financial markets, Nair finds a structural aspect of Indian equity markets that supports the implementation of a long-short strategy. "Indian equity markets often witness periods of significant mispricing between fundamentals and prices. This is because India's economy is largely domestic. As a result, global shocks only have a small effect on cash flows of Indian businesses. However, equity market valuations are highly vulnerable to global shocks since a majority of the invested capital comes from foreign institutional investors. This effect on valuations varies among firms since they differ in the extent to which their profits are insulated to global shocks as well in their ownership patterns. Investors can take advantage of such differences, especially if they look beyond the index constituents."
In terms of the Indian equity markets, Nair reports that many investors in Indian markets fish in the pool of 30 names that constitute the SENSEX or, the 50 names than constitute the NIFTY index. "The structural mispricing among some firms in this universe is low, and the price volatility is high, because of a higher level of exports and revenues from international operations. Indian markets are fortunately populated with a large number of names. Around 700 firms have a market cap of larger than $100m and about 350 firms have a market cap of over $500m."
Looking beyond the largest companies, Nair notes that the opportunities to find companies catering to domestic consumers increases. "In other words, the chances of finding companies less prone to international shocks are higher. For example, 400 out of approximately 1200 listed companies that are between $10m and $200m in market capitalization are in the consumer discretionary and durables sector. This is in contrast to about 30 out of approximately 150 companies that are between $200m and $400m in market capitalization. The fact that emerging companies are finding opportunities in the domestic consumption oriented sectors is an encouraging sign for Indian business" Nair concludes.
How this will help or hinder the growth of a domestic Indian hedge fund sector depends, as ever, on the ability of the manager to short Indian stocks. Technically, you can't short stocks in India using the loan route that exists in the West. However India, along with Korea, has a very liquid single-stock futures market. In India, the single stock futures market, which started in 2001, is five times more liquid than the cash markets.
Nair says: "Because the amount of capital you need to put in to investing in single stock futures is less, it encourages retail activity. Also the tax treatment is different with a lower transaction tax for single stock futures because the government wants to promote derivatives."
In terms of India's fundamental attraction for international investors, most are looking for growth potential and within Asia, India is one of the bigger countries and most likely set to grow. Some commentators have drawn a comparison between India and China. Nair says: "Fundamentally, the question of who is going to perform better between India and China does not mean that the financial markets will perform better - it depends on how it gets priced. As an investor for the long term, I feel comfortable with India because it is a functional democracy and the demographics are set up in a way that will allow domestic consumption to be significant. Essentially, the engine of growth is more stable. It might not be as high as in China but there is a lower risk of decline. falling down to a big low number."
Nair also believes that the structure of growth in India is more domestic and not exposed as much to global shocks. "Chinese growth is funded by exports so affected by global shocks which is not true in India" he says. "Also India is some 10-15 years behind China. The sweet spot for investing in a developing country is when the GDP per capita is $6,000 - $10,000. In India it is $4,500 per capita so there is some way to go."
India has a large and aspiring middle-class of over 75 million households or over 350 million people. "The amount of income and the willingness to spend are both increasing. The increasing amount of wealth is best seen in the increase in the number of millionaires (Indians with investible assets, excluding main residence and consumer durables, of more than $1m). The number of millionaires in India is around 160,000 according to a Capgemini and Merrill Lynch wealth report. That's a threefold increase in the last 10 years based on the same report - almost double that of the increase in US" Nair writes in his commentary. "The willingness to spend is also related to the fact that India is young - over 500 million Indians are under the age of 30. Young India's aspirations are more oriented towards consumption and less towards savings. In addition to growing income and changing attitudes to consumption, growth in credit is also in its early stages. These aspects make domestic consumer oriented sectors particularly interesting".
In terms of local appetite to invest into hedge funds, Nair believes that since 2008, investors have realised that long term positive growth and compounding your wealth through lower volatility investments is a more interesting proposition. "Hedge funds done properly should be down 10 or 20% when the markets are down 50% - that is the lure of hedge funds which people in the US know" Nair says. "Smarter long term oriented investors realise that compounding is a powerful tool to mitigate volatility that can be deployed much better with hedge funds."
Nair believes that India is the US in the 80s on steroids. "It's very early and there's not much appetite for hedge funds but it is growing because of significant wealth creation through entrepreneurs selling their businesses and now managing that wealth. Prior to that everyone kept their wealth tied to the business but now you are looking at family offices launching hedge funds and fund of fund structures. Gold and real estate alone will not satisfy all their investing needs."
Dr Nair was interviewed on Opalesque TV. You can watch that interview here.
Opalesque is planning to hold an Opalesque Roundtable in Mumbai over 2013. Interested parties should contact Matthias Knab at firstname.lastname@example.org.
This article was published in Opalesque's Asia Pacific Intelligence our monthly research update on alternative investments in the Asia-Pacific region.