The Fixed Income Market changes forever! Wednesday, Mar 29, 2023 by: Harsh Agarwal, Head, Alternative Strategies, Tata Asset Management Pvt. Ltd.posted in: counseling, Expert Talks, finance, PMS Articles As the finance bill 2023 passed in Lok Sabha, the fixed income world changed for forever. From 1st April 2023, there will emerge a tax parity across fixed income opportunities. The finance ministry has tried to bring income from debt offering under marginal tax rate. The most popular products namely deposits with banks and NBFCs attracted marginal tax rate on the interest incomes. But interest incomes from other products like MLDs (market linked debentures), corporate debentures, REITs, InvITs, and higher ticket non-linked life insurance policies was attracting lower taxation either because of application of long-term capital gains (LTCG) taxation or interest being exempted from taxes. In the budget proposal presented by the finance minister on 1st February 2023, these tax loopholes were attempted to be plugged. The final finance bill that got cleared last week was a step ahead in that direction, and disqualified applicability of LTCG to debt mutual funds. This means that most of the fixed income offerings will attract marginal tax rate (i.e., tax rate applicable to each individual depending on his tax slab). This brings a level playing field for all the players (debt issuers and deposit accepters) in the market. Investors now merely need to focus on risk, return, and liquidity while evaluating these fixed income opportunities. One of the debt offerings that is not impacted by these tax changes and is likely to gain more popularity are the Absolute Return strategies under Category III AIFs (primarily meant for HNIs). We will discuss this opportunity here as it scores well on all the three criterions of risk, returns and liquidity. Equity Market Neutral Strategies – a compelling fixed income alternative Imagine a fixed income offering that can potentially make 9% – 14% returns p.a. with negligible credit risk, and no lock in. Investors can come in and redeem frequently as per their needs. Market participants/investors have carried various notions about the strategy and many of them are incorrect. So, before we discuss in detail what this strategy is, let me explain what it is not. Participation in equity returns. The returns outcome of the strategy is closer to fixed income and the strategy is likely to have negligible (sometimes even inverse) correlation to equity markets. So, market neutral strategies should not be seen as something that will gain from equity market’s structural uptrend, nor will they exhibit any negative patterns when equity markets decline. Risky strategy. The market neutral strategy does not have any sensitivity with equity markets, hence is meaningfully lower risk that pure equities and exhibit similar risk behavior like low-medium duration bond funds (of mutual funds). High taxation. The taxation of these strategies/funds vary from fund to fund. In Indian context, commonly misunderstood perception is that these funds attract full taxation. There is no law in Income Tax Act which spells out a defined tax rate for CAT III AIFs. The taxation of these strategies will vary depending on the fund structure and the investment choices of the fund. What is Equity market neutral strategy? A strategy that cuts out equity market direction risk and largely makes returns through alpha generation in equally allocated equity long and short portfolios. The fund buys a portfolio of stocks (the long portfolio) that it expects to outperform the market, simultaneously short sells (selling without owning) an equal value portfolio of stocks (the short portfolio) which it expects to underperform. As the two portfolios – long and short are roughly equal in value, the strategy will exhibit negligible sensitivity with the equity markets. There will be days when equity markets will fall and the market neutral portfolio will be up, and vice versa. It cuts out the market direction risk and strives to achieve an absolute return through active stock selection. Such a long-short portfolio will essentially make returns from stock selection – i.e., long portfolio outperforming the short portfolio. If the stock selection goes wrong the fund may see negative returns as well. Let’s understand the strategy better with the help of following illustration* which will bring out the potential risk-reward on a relative basis: Equity L/S portfolio Long portfolio Short portfolio Total Equity index Fixed income MF Allocation -> 50% 50% 100% 100% 100% Yr 1 Returns 32% 18% 25% 5% Derivatives L/S Portfolio 16% -9% 7% Add: Fixed income return 5% 12% Yr 2 Returns 2% -8% 0% 6% Derivatives L/S Portfolio 1% 4% 5% Add: Fixed income return 6% 11% Yr 3 Returns 16% 2% 10% 7% Derivatives L/S Portfolio 8% -1% 7% Add: Fixed income return 7% 14% Total Gross Returns (ignores fees & taxes) 42% 38% 19% Volatility 1.50% 12.60% 1.00% As we can see in above numbers, the market neutral strategy exhibits no correlation with behaviour of equity markets. Its volatility is lot like bond fund volatility. Hence, equity market neutral strategy should be seen as a debt alternative. *The above set of numbers merely constitute an illustration to explain the concept and is reflective of a high performing strategy. Investors will need to evaluate each such strategy after seeing their track record and capabilities of the investment team. What we can also see in the above illustration is a high performing market neutral strategy which can generate alpha in both its long and short portfolio across market phases. This will require a highly skilled fund management team with very strong execution. Additionally, these strategies are highly suited to Indian markets for a couple of reasons: India is a high alpha market across market sections (large, mid, and small caps) which allows skilled stock pickers to make alpha on both the legs, i.e., long portfolio outperforms the market, and the short portfolio underperforms the market on annual basis. Additional fixed income returns. Equity long-short strategy is carried out through derivative positions which doesn’t require any capital outlay. One must simply pledge some securities, say bonds, as collateral with the exchange. This allows the fund to make additional fixed income returns along with derivative strategy returns. How to invest in this strategy? Like globally, there are hedge funds (low risk) that specialize in equity market neutral (agnostic) strategies, in India this is catered through Category III AIFs that deploy Absolute Return strategies. Globally, the hedge funds collectively manage ~$1 trillion in equity long-short strategy. In India, this industry started about a decade back with introduction of Category III AIFs, which was armed with investment tools like use of options, multiple asset classes, and greater investment flexibility including taking both long and both positions. The fund will primarily deal in listed securities and therefore provide redemption flexibility to the investors. Funds specializing in these Absolute return strategies collectively manage ~$1.5bn. Most of the funds in India have done well and given investors better pre-tax returns than the conventional fixed income offerings. With tax parity now emerging across the fixed income offerings, this category of funds become a very attractive choice for the investors. What are the critical success factors: A diversified equity market neutral is one of the low-risk investment strategies but requires very sharp stock picking skills/processes which make alpha. Volatility trading, or trading macros – Fx, interest rates, commodities will require specialists trained in those fields. So, the first and foremost element of a good fund is skill and experience of the investment team. A well-executed strategy will exhibit high returns with minimal drawdowns. Additionally, funds deploying multiple sub-strategies (i.e., equity long-short, volatility trading, commodities trading etc.) should be better as they will likely generate more consistent returns. So, a multi strategy fund with alpha generating managers, with a lead strategy integrator (Strategy head or CIO) who understands the risks associated with each asset class, strategy, and sub strategies, and that of their combinations, and can manage those risks using optimal allocations to each strategy/asset will be the best investment choice for the investors. Disclaimer: Views expressed in the above write-up are personal and not established theories/concepts.