Though the overall growth prospects for economy and capital markets remain high, the last 20 months have taught that stock market investing can go through frequent ups and downs with sharp moves at sector and stock level. Hence, there is an opportunity on the long side as well as short side. This bi-directional scope for returns has led to the significant growth in the space of long short alternative investment funds, which in terms of assets stand at around 15k crore as of Sep 2019.

The search for alternates intensifies when we see the usual faltering or when the usual seems harmful. The world is gungho about electronic vehicles because the usual fossil fuelled vehicles seem damaging to the environment. Similarly, in the investment space the usual investment philosophies have missed the target returns, and hence what is catching interest amongst low risk investors is the long-short style of alternative investing.

Global environment exhibits VUCA (Volatility, Uncertainty, Complexity, and Ambiguity), which could continue for a while. Our country is undergoing strategic policy changes in the business environment. Additionally, new ways of doing business is the future and technology developments are making older ways obsolete. Besides, we’re a tough country to run businesses with multiple regulatory risks, high costs of factors of production, heightened competition at SME/small scale business level, weak credit enforcement laws etc. All these factors are leading reasons for the volatilities across stocks, sectors, and industries. Thus, long trades and short trades both could be winners if the fund managers take the right call.

While all long short funds fall broadly in the same category, individual funds have different investment objectives. Some of them look to produce liquid plus returns, some look to beat NIFTY with active trading, some employ levered arbitrage strategies, a few others use heavy fixed income earnings with a trading overlay, and then there are a few funds which run as a hedge fund where the bulk of the returns are made from equity long-short strategy without participating in market direction.

Our Mumbai Team at PMS AIF WORLD recently conducted an interview with Harsh Agarwal, Head, Alternatives, Tata Asset Management on the investing case for long short funds. Harsh explained that “a diversified equity market neutral AIF strategy is popularly growing amongst HNI investors as it is not only the lowest risk strategy within long/short investing but is also the lowest risk equity strategy for all equity investing”. Here, the aggregate longs (the stocks that are bought) and aggregate shorts (the stocks that are sold through futures and options, without owning them) are roughly equal in size. These are designed to exhibit nearly 1/3rd of index volatility. He added, such a portfolio does not participate in market vagaries, and purely generates returns from active stock/sector selection and out-performance of long book over the short book.

Broadly, there are 3 risks associated with all types of long – short funds: –

  1. Directional trading long – short funds which are looking to generate returns by predicting and timing the market direction, are exposed risks of fund manager’s directional calls. A trending market will favour such a strategy, while range-bound or choppy markets could hurt returns.
  2. Long – Short funds with long bias are funds where longs are more than the shorts. These are prone to market risk, where any weakness in market hurts returns. Additionally, these are exposed to stock selection risks, i.e. which stocks the fund manager chooses to buy and/or sell, and the accuracy (or lack of it) determines the returns.
  3. Equity market neutral long short funds balance the long and short positions. Here, market direction risk (or systemic risk) is lowest, but still, the fund remains exposed to the stock selection risk, which is also the main driving factor for the fund.

Additionally, level of concentration in the fund increases the risks and volatility for all above mentioned three long short AIFs. The Knack of the fund manager and experience of the fund management team influences the performance of long short fund. And, these are the reasons for the divergence in the performance of various types of long short funds