Fledgling Indian Hedge Funds See Growth Setback on Higher Taxes
A commuter wearing a protective mask crosses a road near Connaught Place in New Delhi. (Photographer: Prashanth Vishwanathan/Bloomberg)

Fledgling Indian Hedge Funds See Growth Setback on Higher Taxes

(Bloomberg) -- Assets at Indian hedge funds slumped by a record last year, and their managers are getting ready for more pain to come.

A July tax increase on returns from alternative investments was the main reason for the slide, according to Vaibhav Sanghavi, who oversees funds at Avendus Capital Public Markets Alternate Strategies LLP. The levy was increased by a fifth to 42%, he said. India passed up an opportunity to tweak the tax regime on the investment category in its budget last month, making it unlikely that a reprieve will be offered anytime soon.

The higher tax is hurting prospects for growth in the industry, which is already tiny as alternative-fund holdings comprise only about 0.1% of total equity assets in India, compared with 5% globally, Sanghavi estimates. Domestic hedge-fund assets dropped 6% to $4.6 billion last year from 2018, according to annual data from Eurekahedge, a database for such funds. That’s the biggest decline since 2011, when the firm began compiling data on this category.

Hedge funds are meant to protect the value of investments during market swings. With India’s $2 trillion stock market the most volatile since 2008, two of India’s top funds have adopted various strategies to shield returns. But they both face the challenge of attracting and retaining investors, who have the option of shifting to mutual funds which are taxed at a lower rate.

Fledgling Indian Hedge Funds See Growth Setback on Higher Taxes

“Some funds like ours have placed longer-term equity holdings in a separate account taxed as equities, while the derivatives book is in another account,” said Vijay Krishna Kumar, who manages IDFC Asset Management Co.’s long-short fund, an investment vehicle aimed at delivering returns that don’t align with a benchmark. The equities account gets taxed at a lower rate. “This somewhat mitigates the liability.” Avendus Capital meanwhile has cut fees for clients to cushion some of the blow to investors, according to Sanghavi.

More Hurdles

A higher tax rate isn’t the only obstacle to growth for India’s hedge fund industry. Along with relatively recent regulatory approval to invest clients’ funds in 2012, they face more stringent rules than regional peers in Hong Kong and Singapore. A shortage of derivatives, available for less than 5% of India’s listed companies, also hampers Indian fund managers as they have limited options in taking short or long positions on individual stocks they may consider mis-priced.

Indian long-short funds fare worse than global peers in delivering a return that differs from the benchmark. Their so-called beta -- a measure of how closely they track an equity benchmark -- is 0.71, according to Eurekahedge. That compares with 0.48 for the whole of Asia. A value of 1 indicates returns mirror those of a benchmark.

Despite the challenges, long-short funds still have some appeal for investors looking for shelter in a turbulent market.

“The funds do help in reducing the volatility of investments in equities,” said Amrita Farmahan, who oversees assets management at Ambit Wealth Management Pvt. in Mumbai. “That’s something our clients are willing to pay a premium for.”

Lowering the tax rate for the funds would go some way toward helping build liquidity in India’s equity market, said Sanghavi, who is also co-chief executive officer at Avendus Capital.

“Government revenue can also increase as the industry expands,” he said. “The potential for growth is huge and can benefit both. The problem is entirely solvable, but we will need to work carefully with the government and regulators to understand each issue they have.”

©2020 Bloomberg L.P.

BQ Install

Bloomberg Quint

Add BloombergQuint App to Home screen.