Why allocation to long-short funds makes sense in the sideways market

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The world is going through a phase of geopolitical transition. Such transition always leads to wild bouts of volatility across the asset classes, as we have seen over the past 9-10 months. As businessman and philanthropist George Soros once remarked, “volatility is greatest at the turning point and diminishes as a new trend gets established.’’

The current period of fluctuations is expected to continue for some time as markets adjust to the new normal. Therefore, investors must brace themselves by controlling the volatility of their actions, as advised by financial educator Brian Feroldi.

One of the most effective ways to manage these fluctuations is investing in long-short funds. In these funds, the fund manager buys stocks that are expected to go up and enters into derivative contracts to sell short on stocks that are expected to go down in the future. They expect to make money from these derivative contracts, so as to increase overall returns of the fund, especially in a bear or the sideways market.

Globally, long-short funds are one of the largest categories of alternative assets. The hedge fund industry globally is $4-4.5 trillion and long-short funds form a sizeable chunk of this allocation. However, the long-short category is yet to become meaningful in India.

In India, Category III AIFs (alternative investment funds) account for 66,000 crore, which is 20% of the total funds raised across the three categories of AIFs. Among category III AIFs, pure long-short funds make up around 15-18%, and absolute return strategies make about 10%, while the rest are long-only funds.The long-short and absolute return strategies are often used interchangeably in India.

Less volatile

Typically, a long-only investment approach exposes investors‘ portfolios to market cycles. A bulk 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 the downside in bearish markets, providing the opportunity to rise higher and generate better returns than long-only offerings when the trends turn bullish.

Looking at the most recent period of fluctuation, the long-short funds only fell 4.5% compared to an 11% decline in long-only products during the corrective phase of market over the nine months until July 2022.. The long-short fund performance was calculated based on the average returns of eight funds in the long-short category that are in India, while long-only returns were based on an average of 28 mutual fund schemes in the large-cap category. The long-short funds help preserve capital, and yield better returns because of their ability to harness the power of derivatives through hedges and leveraged shorts. This results in a lesser fall than the market during periods of heightened volatility.

Though there are risks associated with this strategy on the back of short-selling stocks, the well-managed long-short funds with good track record will be able to cushion the fall, and can potentially outperform the market over the long term.

Know the difference

The long-short and absolute return styles, though used interchangeably, are two different strategies.

In absolute return strategies, a significant part of the portfolio is invested in fixed income instruments and the remaining is used to take directional calls in equities with a view to generate returns over the short to medium term. Therefore, an absolute return fund compounds closer to a fixed income rate (around 8-10%). This is why absolute return strategies could be termed as debt ++ offerings while attracting relatively higher tax rates.

In contrast, a major part of a long-short portfolio is invested in equity instruments. Being benchmarked to the Nifty index, long-short funds offer equity-like compounding and aid wealth creation over the long term. The investment objective of both the strategies is different and one must be aware and cautious while investing.

Allocation

Globally, long-short funds are all-weather products as they enhance and complement asset diversification because of their asymmetric return feature. The long-short funds usually complement traditional long-only investing by taking advantage of profit opportunities from undervalued and overvalued stocks. On an average, one can look at 15-20% of one’s equity allocation being apportioned to this strategy. This allocation will offer lower correlation to the rest of one’s traditional long-only investments.

Ajay Vora is fund manager (EDGE), EVP, investment management, Edelweiss Wealth.

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