What are the risks (even for long term investors) that push the need of Equity biased LS funds v/s Pure Long Only Equity Funds?

To understand the merits and risk of Long only equity fund Vs Equity biased Long-Short funds, lets first understand what they are.

Long only equity fund is one which is primarily invested in shares and is likely to follow broader equity markets with some out/underperformance. Here, the investor stands to reap the rewards of structural up-trending behaviour of equities as an asset class. At the same time, the investor will need to face the volatility of the market, and during market crashes and negative sentiment around, investor may panic to exit some part of their equity allocation. In such cases, the long-term returns for the investors and the equity fund can be very different.

Equity biased Long-Short fund is one which runs two portfolios parallelly, a) an equity long only portfolio, and b) an equity short portfolio. Short portfolio comprises of equity positions which the fund has sold (shorted) without owning them with the objective of gaining from stock price declines/underperformance. As the fund is Equity biased long-short fund, it means the size of the long-only portfolio will be bigger than the equity short portfolio, say in ratio of 70:30 or 60:40 etc.

This strategy will have lower dependence/sensitivity to overall market movement and will focus harder on stock selection with short term /medium term view. The long portfolio of strategy will strive to perform better than index while short portfolio should ideally underperform the index or fall in absolute terms. 

Now let us understand the merits and the risks of the above two strategies through following two illustrations:

Scenario 1: Weakish equity market phase

  NIFTY Equity L/S portfolio Long portfolio Short portfolio Total L/S
    Allocation 70% 30% 100%
Yr 1 25% Returns 30% 15%
Portfolio returns 21% -5% 17%
Yr 2 -10% Returns -5% -15%
Portfolio returns -4% 5% 1%
Yr 3 0% Returns 5% -5%
Portfolio returns 4% 2% 5%
Absolute returns 12.5% 23.5%
Volatility 18% 8%

Equity biased long-short strategy has total of 70% in long allocation (Stocks bought) and 30% in short allocation (Stocks short sold). Here, the strategy will have ~40% (i.e. 70% -30%) market sensitivity and hence will exhibit lower volatility. While easier said than done, the strategy will aim for generate alpha on both its portfolios (i.e. long portfolio should outperform index, while short portfolio should underperform index on equal weight basis). At TATA Asset Management Pvt. Ltd. our wisdom is that well-executed stock selection focussed strategy will usually do well across market phases. 

As against this long only equity portfolio (let’s take NIFTY as proxy) will exhibit volatile and unpredictable behaviour.

Scenario 2: Bullish equity market phase

  NIFTY Equity L/S portfolio Long portfolio Short portfolio Total L/S
    Allocation 70% 30% 100%
Yr 1 25% Returns 30% 15%  


Portfolio returns 21% -5%
Yr 2 10% Returns 15% 5%  


Portfolio returns 11% -2%
Yr 3 0% Returns 5% -5%  


Portfolio returns 4% 2%
Absolute returns 37.5% 33.3%
Volatility 13% 6%

Here we see that while Equity biased long-short strategy continues do make alpha returns (i.e. long portfolio doing better than index and short portfolio underperforming index), the short portfolio will be a drag on overall returns in bullish market conditions. Hence the investor taking full equity risk (through long-only equity fund) will be better off.

Having said that, equity markest go through various cycles. Euphoric bullish conditions are an exception rather than a norm. In muted or even normal equity market conditions (NIFTY’s long-term rolling returns are ~12% p.a.), a well-executed long biased equity might turn out better returns for the investors. Additionally, investors tend to panic sell when during market crashes. For investors who have lower risk appetite or who don’t like too much volatility, they are likely to participate better in the market through We, at TATA Asset Management Pvt. Ltd. believe that Equity biased long-short strategy which is better equipped to tide the volatility and bear phases.

Additionally, stock prices react to earnings, business developments, and uncontrollable macro and geo-political factors. What may be risk for long only equity fund, can be a money-making opportunity for a long-short fund. 

Disclaimer: The concept of equity long-short strategy has been explained with illustrations. As the strategies will deal with stocks, there is no assurance that equity markets will deliver high or positive returns and whether alpha returns will be made by funds/strategies.