Q&A With Sanjiv Duggal

Portfolio Manager, HSBC India Alpha Fund

Originally published in the October 2009 issue

With the world economy beginning to show progress in its recovery from the credit crisis, it is timely to consider allocations to emerging markets. The re-emergence of risk appetite makes the Indian market a subject of strong interest to investors. Though is some years behind China in its economic development, it offers investors the opportunity to participate in what will surely be a long-term economic development process.

HSBC Global Asset Management is an investment manager with deep roots across Asia and particularly in India. Sanjiv Duggal, the lead portfolio manager of HSBC India Alpha Manager, is heading a team of four, backed up by the bank’s global emerging markets team in London and its Indian equity team based in Mumbai.

Duggal is well knownto overseas Indian market investors. He is generally regarded as being the biggest investor in Indian stocks with his long-only India Equity Fund having peak assets of more than $11 billion at the end of 2007. This doesn’t leave Duggal is afraid of speaking out – far from it. In December 2007, when the fund was up more than 60% for the year he cautioned that an 18-24 month fallow period was inline for Indian stocks.

Discerning investors will realise that that period is now drawing to a close. The absolute return fund is just a fraction of the long-only investments Duggal oversees. But its commitment to low net-exposure and Duggal’s evident stock picking skills mean that the hedge fund has been one of the best performers in the India space. In August, the fund passed its high water mark. Duggal was in London recently to discuss Indian investing and the absolute return investing philosophy behind the Alpha Fund in an extensive interview with Bill McIntosh, Editor of The Hedge Fund Journal.

Q: How is the macro economic backdrop for India and how has this evolved over the past year?

A: The macro economic background for India is getting better. We think the worst of the GDP growth is behind us and we think as we go forward to March 2010 we should see 8% growth. We expect a fairly sharp inflexion. Three of the other macro economic indicators in India are also improving. One is the fiscal deficit: last year India’s went up very sharply but this year we are seeing it moderate slightly. This compares with the rest of the world where fiscal deficits are getting worse this year. In India you are seeing the reverse, a bit of improvement because last year the government spent a lot of money supporting the economy, mainly due to the elections, but partly due to Lehman.

The second factor is the current account. We think it will swing to a surplus after five years of deficit. We are looking at a $40 billion swing or 4%, from -3% to +1%. On the back of that we think the rupee should appreciate against the dollar. India had a weak currency last year; it fell about 24% versus the dollar. We think that will improve on the back of the current account.

Finally, foreign direct investment, or FDI, is seeing a pickup. Even last year when a lot of corporates found it difficult, India witnessed record FDI coming into sectors like pharmaceuticals, infrastructure, telecoms and real estate.

Q: Tell us very generally the key strategy points of the HSBC India Alpha Fund?

A: Number one, we are a low net exposure fund. We are looking to have net exposure between -20% and +40%. A lot of the peer group tend to have much higher net exposure. On average, we are looking to have about a 25% to 30% net exposure to the market, although since we’ve launched the fund our average net has been just under 20%. We are also looking to run a high gross exposure: typically running between 150% to 200% gross exposure to the market. The portfolio is broken up into two buckets with roughly 50% in each one. The first bucket is our best ideas book, our best long ideas and our best short ideas. The difference between the two would be our net exposure, be it long or short in the range I mentioned. The second bucket is pair trades. This is typically taking pair trades in a sector, so it is sector and market cap neutral as well. There is no net exposure. So that would tend to be the lower risk to return part of the portfolio.

Q: How does the strategy you are running combine top-down macro themes and bottom-up fundamental analysis?

A: We are more of a top-down investor. Initially we are taking a call on which sectors we want to be long and which sectors we want to be short. We take a call on trends in the economic and business cycle. We are trying to identify turning points in the economy and government policy. Then we decide which sectors we should play on the long side and short side as a result of that analysis. Once we have chosen the sectors,then we go on to bottom-up stocking picking where we do a lot of detailed work at a stock level, deciding which names we want to buy or sell. Typically we are larger cap focused. We want to maintain a more liquid orientation in the portfolio.

Q: On a sector basis, with some companies as examples, what are the portfolio’s main long positions and main short positions, and what are the reasons for those choices?

A: The main long sectors would be consumer discretionary, which includes the auto sector. The reason for that is we think that consumption is picking up. In 2008, we had a slowdown in consumption, car sales were negative year-on-year. This year as we have seen interest rates come down quite sharply we’ve seen demand from rural India pick up. Rural India has done very well as the government has pumped in a lot of money, so demand has picked up. Government employees also got a big pay rise last year – roughly about 4.5% of GDP – spread over last year and this year. So a lot of government employees have come in to buy cars. One of the companies we hold is Maruti Suzuki. They’ve got about a 55% market share in India, the widest distribution network and wide after-sales service as well. That company has seen strong domestic growth this year. We’ve also seen record export volumes. The company makes a car in India for Europe. It is sold under the Suzuki and Nissan badge. They are looking at record exports to Europe this year of about 125,000 cars. That’s one of the key long positions in the portfolio and we have about 6% (of the fund) in that stock right now. In recent results we saw operating leverage kick in quite sharply. The company beat consensus numbers by about 250 basis points on operating margins. We’ve seen some very big upgrades to the stock on the back of that. That’s a key long stock.

We’ve also been long real estate – mainly a play on residential real estate – and our key position is in Unitech, India’s second biggest real estate company. That company faced severe problems last year. It had bought too much land and financed the land with shorter term debt so when the credit crunch hit India in the third and fourth quarters of last year the company found it difficult to make repayments. They’d also bought a mobile telecom licence for $400 million. Debt-to-equity was very high – it was over 2:1 – and the company could not meet repayments. That’s when the Central Bank stepped in and Unitech was able to borrow money and reschedule payments to debt mutual funds. This year it managed to sell the majority of its telecom business to Telenor of Norway. That helped bring down debt and they also did two placings of stock. We were big participants in those placings in the series of funds that we run, including the Alpha Fund. On the back of the equity issuance, the debt-to-equity ratio came down to about 0.4:1. So the whole balance sheet of the company improved dramatically and the stock has performed very strongly on the back of the insolvency risk going away.

From a more fundamental point of view, real estate sales in India have started picking up. The company has now turned cash flow positive and it doesn’t need to buy any land for the next 10-15 years. In India, you typically get money up front (from home buyers) and then you construct. So Unitech is in a good position now.

On the short side we have been short technology. The reverse of our play to be long local expenditure is to be short some of the global cyclicals of which one in India is technology or software. Here one of the positions is to be short the Tata Consultancy. Again the reason for short tech is that we think the companies will find it difficult going forward to achieve volume growth. We also see pressure on their billing rates. We think the top line will not be as strong as people are expecting and we think the strengthening rupee will hurt their earnings as well.

Q: Explain your background and how that is important to the fund. And give us a little bit on the experience of your main team members – Viresh Mehta, Divya Balakrishnan and Nilang Mehta.

A: I grew up and studied in India. I came to the UK to do chartered accountancy. After that I went into internal auditing roles. I was an internal auditor in Hill Samuel Group. A background in auditing meant you always had to have an inquisitive mind. We did big picture auditing and strategic auditing. It gave me a very good understanding of how companies operate in different industries. That’s helped on the fund management side. When I became a fund manager at Hill Samuel I got a break through an investigation I was doing for the asset management company to move into fund management. There were very good people at Hill Samuel who trained me up. Hill Samuel was a blend of the TSB people and the original Hill Samuel both of whom had different approaches. I learned from these approaches and my direct boss Allan Burrow was very good.

Since I joined HSBC in 1996, I’ve been able to learn as I went along. It is the type of job where you learn everyday which is part of the fun of being a fund manager. Each day is different and it is very dynamic. The auditing background has helped, as has having a common sense attitude matched with a background in chartered accountancy. Among my colleagues, Viresh has more of an engineering background and he worked as a sales trader on the sell-side. I was a client of his at UBS. He joined my team as a dealer and then moved into fund management. He is more market orientated and has more of a trading orientated view. Divya joined HSBC on the graduate rotation programme in Singapore doing various positions before joining us as an analyst – analysing sectors and companies. Nilang Mehta joined us in August as a fund manager and he will boost our strength on the analysis side. I first recruited him in 2004 and he has relocated from Bombay to Singapore.

We also hook in with our colleagues in London from the global emerging market team and our colleagues in Asia from the Asian team. We take inputs from them but we take the end decision. The other inputs we get come from a morning call from the India team. India has a separate asset management team which runs local onshore funds in Mumbai. They have 10 people on the equity side. We also have a dealing desk in Singapore. I moved to Singapore from Bombay in August 2005 and the other team members have come over since then.

Q: What are the main risk management disciplines that the fund uses?

A: We have a separate risk unit from fund management. It reports into the global risk manager and to my boss, the head of the hedge fund business. We have various limits that are set which we have to comply with. There are broad prospectus limits. Then we have stricter internal risk limits.

The key limits are maximum gross exposure at 250% and maximum net exposure of 50%. Individual positions can’t be more than 8% of the portfolio either way. No more than 25% in any sector. Both are monitored by risk. There is also a soft limit of 10% on any sector. That’s one of the things we learned to do from last year when the markets were extremely volatile, which resulted in us not doing well in September and October.

The other limits are 25% exposure to mid-cap though we have an internal soft limit of 15%. These are all monitored on a daily basis and we get a report that is sent to a number of people in HSBC Global Asset Management and shows how we stack up against the various limits. Those are the key things we monitor by risk.

Q: The risk management is done by an external team?

A: It is managed by the HSBC Global Asset Management risk team – outside our hedge fund team. The global head of risk reports to the global CEO of HSBC Global AM. It is the same with compliance. All the trades we do in our Alpha Fund are compliance checked 100%, meaning they review every transaction we do the following day.

Q: Do you meet with the HSBC Global AM risk management team on a periodic basis?

A: Yes. We meet with them. We get a daily report. They come out to Singapore – they are based in Hong Kong – so there is regular contact on various issues. They look at other things. If, for example, we had P-Notes or access notes with a counterparty, there would be limits on that. They keep reviewing the limits and discuss them with us periodically.


Q: How has the fund performed since it launched in April 2007, both in absolute terms and in comparison with the Indian market?

A: If you take the last nine months of 2007 – we launched in April 2007 – the fund delivered a return of about 23%. In 2008 the fund was down 26%. That was mainly because of September and October. This year in the first nine months (of 2009) we were up 36%. From launch, for 30 months, we are up roughly 23% on a cumulative basis. Over that period of time the Indian market would be up 18% in dollar terms through to the end of July. We’ve done roughly 23% running with around 20% exposure while the market has done 18%. Over 30 months we are a bit below our target return – we are looking to make 15% net return per annum – but it has been a period of extreme volatility. It has been testing times for stock markets and India has been at extremes. It was the best performing market in 2007. It was in the bottom three in 2008 and right now it is again in the top three in 2009.

Overall, we’ve added alpha for the fund, given that with a 20% exposure we have done better than the market’s return. I think the India long/short funds were the worst performing category among equity long/short strategies. A lot of Indian funds were set up that had high net exposure and lost 40% to 50% in calendar 2008. They were running pretty much like a long fund. We were among the funds with the lowest net exposure and a large cap bias. A lot of people are reviewing the space. We want to emphasise that our strategy is very much focused on absolute returns.

Q: How do you handle event risk?

A: We had an election in India in May and we were unsure of how it would go: five years ago the market fell 20% in two days, but this time in went up 20% in a day. All of the experts had a particular result in mind none of which occurred. We took our exposure down to 0%. We weren’t going to take a call. So we were unaffected. But we did quite well in May with our sector positioning, even though we were neutral. Similarly we had a budget in early July. Again it was a big event for the market. But again we didn’t have any clear view about which way it would go.

Typically we are high conviction. We have clear views. But on the budget we weren’t too sure what would happen. The budget was very disappointing to the market. We had gone neutral. On the day, the market swung about 8% to 9% intraday, positive to negative.

Q: What was disappointing about what was in the budget?

A: People had very high expectations. They expected a lot of announcements to be made in the budget. They expected a lower number for the fiscal deficit. The Minister of Finance did not announce any new proposals. People had positioned ahead of it. We had gone neutral; we had done the opposite. We said we didn’t want to run exposure because it was an uncertain event. Once the budget is out you can reposition the portfolio. Normally we are pro-active if we have a view.

Q: What regulatory constraints are present in the Indian market regarding shorting and other market rules? And how do you mitigate the impact of these?

A: From September of last year you are not allowed to take fresh shorts via P-notes. Before that you used inventory held by the investment banks and sold that inventory into the market with a P-note wrapper. Fresh positions in that were stopped in September last year. But India has a big single stock futures market, I think the second largest in the world, so we now use single stock futures to get short exposure. The other change, about two years ago, is that the government encouraged hedge funds to register with the Indian regulator. Now we can buy and sell futures in our own name and we can buy underlying stock in our own name rather than via a P-note wrapper. A bit more transparency has come about. And the Indian stock market is one of the most efficient globally. If you buy or sell a future, you have to have margin money in your account before you trade or you are not allowed to trade. If you buy cash equity, you have the option to settle T+1. In all the volatility of the market it has operated smoothly and hasn’t had to shut. It is a very efficient market.

Q: With the fund growing and making positive returns again, what do you see its capacity constraints being?

A: We are finally seeing clients put money into the fund. We’ve had a drought since the 1st October last year, when we have generally seen money flowing out. (Duggal and Viresh both put in more of their own money on 1st December.) This month-end there is some decent money coming into the fund and there are a few other clients who are looking to allocate money. The fund did reach $350 million but now it is around $117 million.

Q: Is the largest category of investor funds of funds?

A: No, not any more. Institutional is around 30%, fund of funds about 30% and about 30% private bank allocations with the main money from high net worth investors. A lot of redemptions were from fund of funds. Right now we are fine with the size limit and the soft close is a long way away.

Q: What is the operating environment like in Singapore for hedge funds?

A: We are regulated by the Monetary Authority of Singapore. Our funds are also registered with SEBI, the Indian regulator. Singapore tends to be an environment that is pro-businesses like hedge funds, private banking and wealth managers. The authorities have encouraged firms to set up in Singapore and the government has been quite supportive of these types of industries.

Q: How would you characterise the growth that has happened in the hedge fund community in Singapore in the last couple of years?

A: I think it has to be divided into pre- and post-Lehman. Pre-Lehman, you saw a lot of people move to Singapore to set up hedge funds. Post-Lehman, it has been a lot tougher to get money in and you have seen some funds close down as well. But pre-Lehman, Singapore was one of the favoured destinations. Living conditions are very nice. There is no pollution. It is an easy city to get around and is English speaking.

We did see a lot of people move to Singapore, but right now it is difficult to get money in. For a stand-alone hedge fund, some people say it’s harder. Even for us as part of HSBC it has been tough until this month to get money in. Not to mention being in the India space, which is difficult because India managers did pretty badly. We were one of the better performing but we were still negative 20% or so.

It is a combination of those factors. But we are seeing a lot more people move to Singapore. People who relocate there tend to like the lifestyle and it is very good from a family perspective.

Q: Obviously India and China vie for being the biggest emerging markets in Asia. How do you compare and contrast the opportunities for hedge fund investors in India versus in China where more hedge funds are found?

A: India has one of the most diversified stock markets. We have a lot of sector representation. With India you have a broad spectrum of sectors and there are a lot of sectors to choose from to go long or short. There is no one single dominant sector. The largest sector might be about 25% of the benchmark. In China, it is more concentrated around financials and telecoms. India is more diversifiedfrom our top-down perspective. It gives us more opportunity. India also has a lot more listed stocks. The stock market is a lot more transparent. There are a lot of world class companies and entrepreneurs in India. From a hedge fund perspective, I think in India it doesn’t really matter what the market does – you are going to see more sustainable growth. For a low net hedge fund that is less important but for a higher net hedge the sustainable growth opportunity is maybe more of an important issue.

Q: But surely India, not having China’s share classes, is more open to foreigners?

A: Foreigners and locals can buy the same local listed stock. Sometimes companies have American depository receipts and global despository receipts. Some stocks in India have a foreign cap. The minimum laid down by the government is 24% and the companies are free to increase it up to 100%. There are some limits there but nothing significant and you can get around it with single stock futures. The limits don’t apply to futures.

The other reason why hedge funds didn’t do well in India last year was the sharp depreciation in the rupee. Coupled with the regulatory change I mentioned earlier – where you could no longer take P-note shorts and you had to switch to single stock futures – (on a future when you sell short you have to pay margin money upfront) instead of 100% short exposure through a P-note short it became 70% because you had to pay 30% margin money in rupees. So you automatically become more long the rupee and you also had to keep a rupee balance in India because you are not allowed to deal futures unless you have the margin up front in your bank account. To mitigate that from February to March onwards we started to hedge the rupee even though we think the rupee will appreciate. We hedge part of our rupee exposure in the fund because we don’t want to lose performance if the rupee slips.

Thanks, Sanjiv.