Hedge Funds in Nepal | What you should know

Amidst recent talk of the Securities Exchange Board working on regulations for Alternative Investment Funds such as private equity and hedge funds, it is an interesting time for the growing financial sector in Nepal. Here's what you should know about hedge funds:

Pooled Funds:

Similar to the way mutual funds are managed, hedge funds are investment vehicles that are run by Hedge Fund managers who look after investments as well as operations. The investors are qualified investors called Investment Partners. Hedge Fund managers usually charge a high fee based on their track record. There is a common 2-20 rule: fund managers are paid 2% of asset value at all times- good or bad- and 20% of profits. Hedge funds also have a lock-up period. The funds would be redeemable only after the expiry of such period and withdrawal before expiry would only be possible by paying a penalty. Lock-up period can range from days to years.

For High Net Worth Individuals only:

Hedge Funds are privately offered to institutional investors and high net worth individuals mainly because of the risk involved and lack of investor awareness. Institutional investors could be banks, insurance companies, pension funds etc. Therefore, there will be no IPOs for hedge funds as funds are collected entirely through private placements. For example, only individuals with a network of above $1 million or those with annual income above $200,000 can invest in Hedge Funds in the United States. The minimum ticket size for investments in India is INR 1 crore.

High Returns, Low Risk

An oxymoron, really. Hedge funds are primarily focused on providing high consistent returns, also sometimes measured by "Active Returns" (by how much does the fund outperform the market) Hedge fund managers have an eye on risk and develop a strategy to hedge risks on their investments. Leverage is a key investment strategy of hedge fund managers which means fund managers buy securities by paying only margins which allows larger appetite for investments. Although low risk is an objective, hedge funds are actually characterized by high risk primarily because of:

Little regulation

Hedge funds can invest in a wide array of assets. The focus is on high returns. This can only be possible if fund managers are given near to unlimited authority. Usually there is very less reporting requirement (and therefore, low transparency) opposed to the stringent reporting required for mutual funds. The SEC in the United States has now regulated Hedge Funds to some extent after the 2008 Financial Crisis, with the Dodd Frank Act being an example. The regulation that SEBON is working on is to create the framework that will cover areas such as investments, participants etc. which brings us to:

Investment Avenues:

Stocks, bonds, hybrid instruments, currencies, commodities, derivatives and even real estate. Some times hedge fund managers also try to gain from merger arbitrage. The key here is diversification. This will also be the major challenge for SEBON as well as fund managers in Nepal as the bond market is almost non-existent and we don't have stock options or futures which could help managers hedge their positions. Whether or not SEBON should allow investments in currency and commodities will be a major question as the investment climate in Nepal is at a nascent stage with very few understanding the risks involved.

Major Challenges:

• Equity Hedging not possible: Arguably the most widely used Hedge Fund strategy and which is not applicable in Nepal as short-selling is not possible here.
• The absence of derivative markets means hedge fund managers cannot invest in not just complex derivatives such as collateralized debt obligations (CDOs) but even options or futures.
• Regulation: If you regulate too much, the fund becomes basically a mutual fund. No regulation and there is the risk that investors lose out.
• Experts. With a baby-faced financial market, we haven't seen enough cycles. Forget black swans, would investors be able to trust experts of the industry?
• Risk Management: Hedge funds require sophisticated risk management techniques, independent risk officers. Another Human Resource issue.
• Less arbitrage opportunities in bonds and convertible bonds as no effective trading of bonds is a major setback.
• Tax clarity: Although it could be assumed that taxation would apply to hedge funds in the same way as it does to mutual funds, more clarity would be welcome
• Laws: With laws permitting too much leeway to financial criminals, will investors trust fund managers?

To ensure some form of accountability, only banks and their investment banking subsidiaries should be allowed to operate and manage hedge funds.

Conclusion:

While it is definitely a step ahead for the financial market in Nepal, regulators should tread with caution. To ensure some form of accountability, only banks and their investment banking subsidiaries should be allowed to operate and manage hedge funds. Such banks or managers should be the major investment partner. Even so, the avenues for investment will remain a concern as fund managers would have to limit themselves to stocks, plain-vanilla fixed deposits and, perhaps, real estate. The question is, would that be enough to excite investors? Perhaps, we ought to develop our bond market first.