The world is passing through a geopolitical transition. As we have seen in the last 9-10 months, such transitions always lead to volatility in asset classes. As businessman and philanthropist George Soros once remarked, “volatility is greatest and subsides as a new trend.”
The current period of volatility is expected to continue for some time as the market adjusts to the new normal. Therefore, according to the advice of financial educator Brian Feroldi, investors should take care of themselves by controlling the volatility of their actions.
One of the most effective ways to manage these volatility is by investing in long-short funds. In these funds, the fund manager buys stocks that are expected to go up and enters into a derivatives contract to sell short on stocks that are going down in the future. They expect to make money from these derivative contracts, in order to increase the overall return of the fund, especially in a bear or sideways market.
Globally, long-term funds are one of the largest categories of alternative assets. Globally, the hedge fund industry is worth $4-4.5 trillion, and long-term funds form a large part of this allocation. However, the long-short category is yet to make sense in India.
In India, Category III AIF (Alternative Investment Fund) accounts for 66,000 crore, which is 20% of the total funds raised across the three categories of AIFs. In Category III AIFs, pure long-short funds make up about 15-18%, and absolute return strategies make up about 10%, while the rest are long-only funds. Long-short and absolute return strategies are often used interchangeably in India. ,
less volatile
Typically, a long-term investment approach exposes investors’ portfolios to market cycles. A large proportion of traditional equity offerings are benchmark-hugging and therefore tend to rise and fall in line with the broader indices. The long-short strategy allows the fund manager to calibrate the net exposure according to their bullish or bearish outlook. This limits downside in bearish markets, provides the opportunity for higher growth and generates better returns than only long offers when the trends are bullish.
Looking at the most recent period of volatility, long-short funds fell only 4.5%, compared to an 11% drop in long-only products during the market’s corrective phase in the nine months to July 2022. The performance of the long-short fund was calculated based on the average returns of eight funds in the long-short category that are in India, while the long-only returns were based on an average of 28 mutual fund schemes in the large-cap category. Long-short funds help to preserve capital, and deliver superior returns due to their ability to harness the power of derivatives through hedges and leveraged shorts. This results in less downside than the market during periods of increased volatility.
While there are risks associated with this strategy behind short-selling stocks, well-managed long-short funds with a good track record will be able to cover the downside, and potentially outperform the market over the long term.
know the difference
Long-short and full return styles, although used interchangeably, are two different strategies.
In absolute return strategies, a significant portion of the portfolio is invested in fixed income instruments and the remainder is used to take directional calls in equities to generate returns in the short to medium term. Therefore, an absolute return fund tends to be closer to a fixed income rate (around 8-10%). This is why absolute return strategies can be called Debt++ offerings while attracting relatively high tax rates.
In contrast, a major part of the long-short portfolio is invested in equity instruments. Being the benchmark of the Nifty index, long-short funds offer equity-like compounding and help in wealth creation over the long term. The investment objective of both the strategies is different and one must be aware and cautious while investing.
allotment
Globally, long-short funds are all-weather products as they enhance and complement asset diversification due to their asymmetric return feature. Long-short funds typically complement traditional long-only investments, taking advantage of opportunities to profit from undervalued and overvalued stocks. On an average, one can look to divest 15-20% of their equity allocation into this strategy. This allocation would offer little correlation with the rest of one’s traditional long-only investments.
Ajay Vora is the Fund Manager (EDGE), EVP, Investment Management, Edelweiss Wealth.
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