Foreign mutual funds that invest in Indian shares are trailing onshore rivals by the widest margin in 13 years due to a dive in the rupee, raising the risk of sharp investor withdrawals unless funds embrace unfamiliar and costly currency risk hedging.

The contrast in performance highlights how foreign funds - there are nearly 180 of them collectively managing some $32 billion - have been caught off-guard by volatility in the Indian currency, and many may now have to take on hedging mechanisms.

"The philosophy for most offshore funds that run dedicated India strategies is that they want to take an explicit call on India as a whole," said Binay Chandgothia, a managing director at Principal Global Investors that manages over $200 billion.

"Hedging is not a huge focus for a lot of them."

The rupee has dropped more than 16 percent against the U.S. dollar since July, making it Asia's worst performing currency this year. That has piled on the agony for foreign investors already suffering from a near-25 percent slide in the BSE Sensex this year.

India-focused foreign stock mutual funds have seen cumulative outflows worth $4.5 billion this year to end-November, according to data from industry tracker Lipper. Their Indian peers have seen net inflows worth $1.34 billion, data from the Association of Mutual Funds in India showed.

Offshore equity funds lost an average 31.4 percent in January-November, 11.6 percentage points more than the average loss in funds based in India, Lipper data showed. Onshore funds manage $37 billion in assets.

The last time foreign funds underperformed by more was in 1998 when they gained 4.3 percent on average, but lagged the 17.7 percent average return of onshore equity mutual funds.

Losers & A Few Winners

Barring two funds betting on the consumer goods sector and two arbitrage funds run by the fund unit of Goldman Sachs in India, all equity funds have posted negative returns in 2011.

Funds that focus on infrastructure lead the pack of losers.

The worst performers to end-November are HSBC India Infrastructure Equity and OkasanAM India Infra Related Equity, down 59 percent and 45 percent, respectively. Both funds measure their performance in Japanese yen, which has strengthened more than a fifth against the rupee, adding to the losses from falling infrastructure shares in Asia's worst-performing stock market this year.

Japan-based, India-focused funds manage $5.5 billion, the highest among the offshore funds. Their return divergence with onshore peers was 15.6 percentage points, Lipper data showed.

Vijay Krishna-Kumar, adviser to the TCG IndiaStar hedge fund founded by Purnendu Chatterjee, a former adviser to investor George Soros, said the divergence will drive people to hedge more, though much of the damage has been done.

"As with most things, the moment most start doing it, that will be the time to buy the rupee. It already looks way overdone short term (but short term only)," he said in an email response to a Reuters inquiry.

Hedge Funds

In the second half of the year, exposure to foreign exchange risk made Indian hedge funds the worst performers in the global hedge fund industry, according to Eurekahedge. That's partly due to the way hedge funds investing in Indian equities are required to operate.

Due to regulatory restrictions that prohibit foreign investors from going short Indian shares on the cash market, hedge funds have to use the country's large single-stock futures market to hedge long positions or make outright bearish bets.

However, 20 percent of the value of the short exposure needs to be paid to domestic brokers as margin. As this is in rupees it further adds to the currency risk, according to Farhan Mumtaz, a hedge fund analyst at Eurekahedge in Singapore.

For those looking to manage foreign exchange risk, there are a few options but they tend to be expensive.

Buying rupee forward contracts, which would lock in the exchange rate at the time the contract was entered into, would, on average, take 5 percent off the annual bottom line.

"Both hedge funds and long-only funds in India generally don't hedge because of the prohibitive cost," said Hong Kong-based Ravi Mehta, founder of India-focused hedge fund Steadview.

Moreover, many investors actually want funds to take exposure to the currency, reckoning the rupee will appreciate over the long term given India's economic fundamentals, say market experts.

Forex Know-How?

But those assumptions have unravelled this year as political inertia, a high import bill due largely to crude oil and gold, and deleveraging in Europe's banking system, which has triggered a scramble for dollars, have battered the rupee.

"They remain completely unhedged on the currency exposure and therefore take a massive hit when the rupee depreciates as it has in 2011," said Gautam Prakash, founder of United States-based hedge fund Monsoon Capital.

Monsoon India Opportunities is down just 3.8 percent this year, which Prakash said is partly because they actively hedged out currency exposure.

Others may have been less nimble.

Dhruva Raj Chatterji, a senior analyst at Morningstar in India, said some firms offer variants of funds which can do hedging, but these had relatively small assets and haven't been able to protect the downside this year.

The offshore non-deliverable forwards market in the rupee is among the most liquid in Asia, with the Chinese yuan and Korean won. Global banks carrying out trades for themselves or for foreign institutional investors playing India are the dominant participants.

"Many long/short managers do it, but it's unclear as to how investors may view this since it also demands an FX competence, which may be outside the remit of many managers," said TCG IndiaStar's Kumar.

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