The Long and Short of Long-Short Funds

Posted on: August 13, 2019 | By: Nalin Moniz

The Long and Short of Long-Short Funds

Hedge funds are a recent addition to the Indian alternative investment landscape, when the SEBI Alternative Investment Fund (AIF) Regulations were notified in 2012. Prior to 2012, alternative investment strategies that involved public equities were limited to long-only portfolios or one-off offerings from brokerage houses. However, the meteoric growth of Category-III AIFs has demonstrated that there is tremendous investor demand for these funds. In the past 6 years, Category-III AIFs have garnered Rs 37,698cr of AUM and the category has grown at a 160.9% CAGR over the past 3 years – the fastest in the Indian asset management industry. In contrast global hedge funds manage USD 3.2 trillion and this has grown 10.1% over the past 3 years. In this section, we will shed light on key trends in the Indian hedge fund industry as well as cover client suitability, strategy evaluation, manager selection and risk management.

Indian equity markets have three distinguishing characteristics that make them ideally suited for hedge funds – or funds that invest in public securities with a risk-managed approach.

First, the long term returns from equities are attractive – over the past 15 years, the NIFTY has delivered a compounded return of 13.56% and the CNX Midcap index has done even better at 15.71%.

Second, this long-term compounding has been punctuated by bouts of high volatility that investors have struggled to handle – the NIFTY was down -51.79% in 2008 and has spent 17% of the time in the same 15 years being down more than 20% from its peak. You have seen a 20% drawdown in the NIFTY on average once every six months!

And third, there is a high degree of dispersion in the performance of individual stocks – both in terms of their fundamentals and their returns – the average spread between the top half and the bottom half of the BSE 200 is 21.35% per year.

These three together make our market ideally suited for a more risk-adjusted approach to investing in equities and for active management over passive management. In fact, the success of equity mutual funds where 84.8% of funds by AUM have beaten their benchmark over the past 5 years demonstrates that India is a stock picker’s market.

We will focus on long-short equity portfolios offered on category III AIFs as representative of hedge funds. These funds collectively have about 16,000cr in AUM today. It is possible to offer some hedge fund-light strategies in a mutual fund or PMS format, but the lack of leverage and tighter restrictions make them easier to understand.

A basic premise of any alternative investment is that it must be an alternative to a traditional investment option – hence the name “alternative”. In the present context, hedge funds are evolving on two main tracks: funds that are an alternative to equity in a client’s asset allocation – like the Edelweiss Alternative Equity Scheme; and funds that are an alternative to fixed income in a client’s asset allocation like the Avendus Absolute Return Fund and the Edelweiss Alpha Fund. Equity alternatives aim to offer similar or higher upside than an equity mutual fund but with a lot lower drawdown and risk while fixed income alternatives aim to offer higher yields than a debt mutual fund with the same consistency and capital preservation focus. Both categories of funds are characterized by an emphasis on absolute returns rather than returns relative to a benchmark – which is the focus of mutual funds. The benchmark for Indian hedge funds that are absolute return in focus is often CRISIL Liquid + a spread for a risk premium. If managers can deliver on these mandates it is not hard to imagine how popular this category will become.

So how do they do it?

The three key tools in a hedge fund manager’s arsenal are flexibility, shorting and the use of leverage.

Flexibility refers to an ability to vary the percentage of debt and equity in the portfolio, the mix of asset types and sectors and other portfolio parameters without constraint. Equity mutual funds are always constrained to have at least 65% of their AUM in equities and most funds shy away from taking large cash calls in their portfolios. In contrast, hedge funds have the flexibility to reduce exposure dramatically when markets are bearish, the freedom to not hug the benchmark and the foresight to be early adopters of new instruments such as Invits which the mutual fund industry has been slow to adopt.

Shorting is done through both the index and single stock futures and options segment. India is one of the rare countries to have a vibrant single stock derivatives market with 201 different counters. Shorting is a valuable tool to not only hedge risk in the portfolio and but also to express bearish views on individual stocks. Just like managers can pick stocks that are expected to rise in value, they can also pick stocks that are expected to fall in value. Stock picking on the long side has been very well explored over the years, but stock picking on the short side remains an open pasture and a fertile hunting ground for alpha. There is a lot of research and effort put into identifying stocks that are likely to do well, but not enough effort put into identifying stocks that are likely to do poorly.

Category III AIFs are the only domestic asset management vehicles that allow the use of leverage, but that too in limited amounts. SEBI has capped leverage at 2x on a gross basis with detailed and has stringent guidelines on offsetting, the calculation of leverage, risk management practices and reporting. The best practices from global regulations such as UCITS have been adopted and this prudent approach has seen the industry navigate turbulent times without any major losses. To clear a commonly held misconception, funds use the additional leverage to reduce risk through hedging not to amplify risk by taking on outsized positions. The cap of 2x on gross leverage means that strategies involving fixed income, currencies or any low volatility asset class will not make sense. It also means that funds will have to be run more conservatively than portfolios managed by individual investors – and rightly so because managers have a fiduciary standard when managing client money.

Put together and if managed well, investment flexibility, shorting and the use of leverage can lead to attractive risk adjusted returns and a very interesting client proposition. So how does one get around to evaluating funds and selecting the right one?

The evaluation of hedge funds has two critical components: an investment evaluation and an organizational and operational evaluation.

On the investment side, a manager must be evaluated on five critical skills.

  1. They must outperform on the long side or on their bullish bets.
  2. They must outperform on the short side or on their bearish bets.
  3. They must be adept at non-market linked opportunities such as high yield debt, arbitrage or special situations.
  4. They need to have a defined process for capital allocation.
  5. And perhaps most importantly, they need to have robust risk management policies and frameworks.

Unlike mutual fund managers who are largely homogenous in their approach, hedge fund styles can vary dramatically. Some managers have short term trading led approaches while others have long term investment led approaches; in some cases longs and shorts are linked through the use of pair-trading and in others they are run separately; some funds are closer to market neutral and run very low beta while others have portfolios with higher beta; some funds actively trade options while others eschew them entirely. The use of derivatives also means that cash utilization and economic exposures are not the same. This often confuses investors who are used to long-only portfolios where the two are the same. Hence, it is worth asking each manager how cash utilization differs from economic exposure.

The Indian market is still evolving, and managers have a shorter track record (3-4 years) compared to their mutual fund peers who in some cases have a track record of two decades, so it is important to look at each potential manager independently and ask them both qualitative and quantitative questions on the five skill sets laid out above. We anticipate that over time either global evaluators & databases like Mercer or Eurekahedge or local evaluators like Value Research and CRISIL will do this for you but for now this key due diligence is left to a client’s advisor. Thankfully, there are only a handful of managers now and this is not as daunting a task as it seems. We caution against chasing returns on this category of funds, because past performance may not be indicative of future performance especially when portfolios are dynamically managed.

Hedge fund sponsors range from established financial service players such as Edelweiss and DSP Mutual Fund to boutiques such as Unifi and Avendus. Given the range of firm sizes and the idiosyncratic style of each of the funds it is important to evaluate the ability of an organization to deliver on the mandate of the fund beyond a single star fund manager. This is especially important because the minimum investment amount of Rs 1cr represents a material financial commitment for an investor. An independent risk management function, a documented process driven approach, fund manager & investment team experience and the commitment of both the firm and the fund manager to invest in the fund are important elements of this evaluation.

We also encourage clients and advisors to focus on operational best practices including reporting of post-fee, post-tax returns; methodology for calculation of tax and performance fees; disclosure of portfolios and risk metrics; and transparent and relevant monthly attribution and commentary. We hope that SEBI prescribes a uniform reporting standard for all AIFs as it will build investor trust and confidence in the industry. But in the meantime, managers that adopt operational best practices and are client-first in their approach are likely to see their businesses grow faster.

Globally, hedge funds are a $3.2 trillion industry and occupy approximately 5% of investors’ portfolios. We anticipate that the local industry will grow approximately 5X from Rs 16,000cr to Rs 80,000cr in the next 5 years with a core set of 10-12 credible and large managers who will collectively manage 80% of these assets. The focus is likely to remain equity-oriented strategies like equity long-short but may also expand to include newer asset classes like commodities. A secular decline in interest rates will drive investors to hunt for yield and is a catalyst for funds that are fixed income alternatives. While, diminishing outperformance in the large cap mutual fund space is likely to drive a separation of alpha and beta with investors choosing to invest in low cost ETFs and equity-oriented hedge funds. In the meantime, we encourage clients and advisors to give the industry a try – the present set of managers have done very well for investors and have the right ingredients to keep delighting investors with strong risk-adjusted returns.