The Long & Short of Hedge Funds

The world of finance thrives on complexity, and few corners embody this more than the realm of hedge funds. The Indian hedge fund industry, up until now, was accessible only via AIFs and, due to their high minimum threshold, was confined to investors with deeper pockets. That is set to change.

With the regulator having relaxed the norms, a much larger base of investors can now access these strategies. An altogether new category of funds has been created - SIFs, or Specialized Investment Funds - with a much lower threshold. Two asset management companies have already launched their schemes, and many more are in the process.

Investing in these funds, however, either through AIFs or SIFs, requires a thorough understanding of their complex risk-return trade-offs. They employ strategies that make them fundamentally different from conventional equity and debt funds. Having said that, these funds can add an important dimension to an investment portfolio, especially in a changing world order where financial market volatility is expected to increase.

This detailed article aims to provide a clearer understanding of these funds, the complex strategies they employ, and the jargon that is part and parcel.

(A) Breaking Down the Jargon

The word hedge comes from the Old English word hecg, meaning a fence or barrier. In finance, to hedge is to take actions to reduce potential losses, much like a hedge protects a garden from unwanted elements.

Hedge funds are named for their original purpose: to hedge, or protect, investments from market risk by using both long and short positions to offset potential losses. While modern hedge funds employ a broader range of strategies and can be very risky, the name reflects this core concept of risk mitigation and protection through simultaneous betting on both rising and falling market prices.

The first hedge fund was founded by Alfred Winslow Jones in the mid-20th century. His strategy involved taking both long, betting on price increases, and short, betting on price decreases, positions in stocks to hedge against overall market downturns. By going long on undervalued companies and short on overvalued ones, Jones aimed to insulate the fund from market volatility while still capturing profits from individual stock picks.

Over time, the hedge fund industry has evolved beyond simple hedging strategies. Today, hedge funds employ a variety of complex, and often highly risky, investment strategies, including leveraging capital and trading across different asset classes.

This also brings us to the other meaning of the word hedge - which is to avoid giving a direct answer. The risk-reward equation of these strategies is not as straightforward as investing in stocks or bonds. A simple yes or no answer is often difficult and not warranted.

# Long, in financial market parlance, means buying an asset - a stock, a currency, a commodity. You stand to gain if the price goes up. Short, in financial market parlance, means selling an asset you do not own. You gain if the price falls.

(B) Demystifying Long-Short Strategies

At the heart of most hedge funds lie the two words long and short. Unlike traditional mutual funds that simply buy and hold, long-short funds engage in both going long on assets they believe will rise in value and going short on those anticipated to fall. This creates a fascinating dynamic.

Many investors have heard of or invested in arbitrage funds as a means of temporarily deploying short-term surpluses. They are, in general, considered safe. The fund takes a simultaneous long position on the stock of Company A and a short position on the futures of Company A for the same amount. Since most times, the futures of an underlying stock trade at a premium to the stock, the fund pockets the difference, irrespective of which way the price moves. Arbitrage funds are among the closest examples of a practical hedge since the fund has gone both long and short on the same company, for the same amount.

Now, let us start to complicate the equation. Imagine a fund that is investing in Company A, expecting its value to rise, and simultaneously taking a short position in its competitor, Company B, anticipating its value to fall. The fund manager is betting that Company A will do better than Company B in terms of stock performance.

• Best case scenario: Company A stock goes up and Company B stock goes down. The fund makes money on both positions.
• Good case: Company A stock goes up more than Company B, or Company A stock falls less than Company B. The fund gains the differential.
• Bad case: Company A stock goes up less than Company B, or Company A falls more than Company B. The fund loses the differential.
• Worst case: Company B stock goes up and Company A goes down. The fund loses money on both positions.

These kinds of trades are usually bucketed under market-neutral strategies, specifically known as pair trades. Here, the fund identifies two securities whose prices should theoretically move in lockstep but have temporarily deviated. By taking a long position in the undervalued security and a short position in the overvalued one, the fund capitalizes on this mispricing.

Complicating it further, the above example looked at two correlated stocks. What if the fund goes long on a banking stock and short on an uncorrelated tech stock? The fund manager is making a deliberate call that the long position is expected to go up and the short position is expected to go down.

This logic can also be applied to asset classes. If you expect equity markets to do poorly and gold to do well, you could short an equity index and go long on gold. Such trades are no longer market neutral, as the prices are not anticipated to move in tandem.

Now, imagine a fund with a total corpus of INR 1000 crores. It is bullish on gold and bearish on Nifty-50. It could decide to buy INR 500 crore worth of gold and use the remaining INR 500 crore to short Nifty-50. In this case, the fund is only using the resources it has.

What if it extends itself? That is, it borrows - using leverage. It could then go long on gold for INR 1000 crore and short Nifty-50 for an equal amount.

Leverage brings a whole new dimension to the risk-reward equation. If the decision goes in the fund manager's favour, the returns are magnified. If it goes against, it can lead to the closure of the fund and significant investor losses. In the world of hedge funds, it would not be wrong to say that over-extending, or leverage, is what defines them.

(C) Understanding Net Exposure vs. Gross Exposure

The distinction between net and gross exposure is crucial. Gross exposure is the sum of all long and short positions. Net exposure is the difference between the long and short positions.

Generally, but not necessarily, a low net exposure means the fund is less affected by overall market changes, minimizing directional risk. A high net exposure makes the fund more sensitive to market movements, amplifying both gains and losses. The gross exposure, on the other hand, tells you how much leverage the manager is employing or if the manager is over-extending the fund's resources.

The net position in several examples can be zero, but the implications can be very different. Likewise, the gross position in an arbitrage example can look similar to a leveraged example, while the risk is entirely different.

The big difference is that an arbitrage fund is shorting the futures of the same stock and it is a near-perfect hedge, whereas if the asset class where the fund has gone long falls sharply and the asset class where the fund has gone short rises sharply, the fund can lose all its capital. There have been several such instances in global history. Long Term Capital Management is often quoted as its collapse nearly caused a global financial meltdown.

More recently, in January 2024, Singapore-based Asia Genesis Asset Management liquidated its hedge fund after a significant and unprecedented drawdown following missteps in Chinese and Japanese bets. The fund increased long positions in Hong Kong and China and was short in Japan, based on the prediction that China would outperform Japan. In that period, they lost money on both trades.

As is evident, the long-short strategies used by hedge funds operate on an entire spectrum. While at one end there are arbitrage funds, at the other end there are funds which employ leverage. And the leverage is not restricted to two times as mentioned in the simple example above. It can be a lot higher. Things get more complicated when funds use options as a strategy.

And hence, it is very crucial to understand the personality of gross and net exposures while evaluating long-short strategies, as two funds with the same gross exposures or net exposures can have very different risk-reward profiles.

Also important is to understand the DNA of the institution involved, especially with respect to its risk management policies. Undoubtedly hedge funds are helmed by some of the sharpest minds in the world of investments. This strength is also their biggest weakness, and hence it is important to assess their temperament as managing risks and yet generating good returns makes their job challenging and stressful.

(D) Other Strategies Used by Hedge Funds

While long-short strategies lie at the heart of many hedge funds, there are several other distinct approaches. Another key aspect is the fund management style: quantitative versus discretionary.

A quantitative fund relies on systematic, data-driven methods, such as mathematical models and AI, to make investment decisions. A discretionary fund relies on human skill and acumen. Over time, some discretionary styles can be codified into systematic programs.

• Event-driven strategies: capitalizing on corporate events such as mergers, acquisitions, and buybacks.
• Option strategies: involve active trading in options, employing strategies like spreads and volatility trading. The complexity of options means these funds can be like a black box to most investors.
• Global macro funds: involve investing based on macroeconomic trends, such as interest rates or currency fluctuations. These funds can take both long and short positions.
• Absolute return funds: aim to generate a profit in any market condition by using strategies like long-short and options trading, rather than trying to beat a market benchmark.

Unlike absolute return funds, traditional hedge funds rely more on their ability to identify undervalued and overvalued stocks, sectors, and asset classes, a concept that can be easier to comprehend, though consistently executing this is challenging and burnout among fund managers can be high.

It is important to remember that not all hedge funds are created equal. While investors must be mindful of what they are signing up for, the Indian market regulator has been quite mindful of the risks, which is why access was kept restricted to high-threshold AIFs until the recent introduction of tightly controlled SIFs.

(E) Specialized Investment Funds (SIF)

Traditional mutual funds

• Buy a stock or a bond or a commodity, such as gold or silver, or real estate units, such as REITs, with the expectation that what they have bought will go up in value. And at some stage, they sell what they have bought.
• Only deploy the funds provided to them by investors. They cannot use leverage. They do not short or use any kind of derivatives, except for arbitrage strategies.
• Their gross and net exposure will be the same and will be equal to the corpus of the fund.
• Need a minimum of INR 5,000.

Specialized Investment Funds (SIFs)

• Besides buying a stock or a bond or a commodity, such as gold or silver, or real estate units, such as REITs, can also short any of them, up to 25% of fund corpus.
• Only deploy the funds provided to them by investors. Same as traditional. They cannot use leverage. However, they can short and can use derivatives, up to 25% of the fund corpus.
• Their gross exposure cannot exceed 100% - hence equal to the corpus of the fund. Their net exposures can vary depending on what percent of the short exposure limit they have utilised. Assume a SIF has a corpus of 1000 crores. The fund has gone Long for an amount of 750 crore, it can go up to 1000 crore. The fund is allowed to go Short for up to 250 crore, 25% of corpus. Hence the net corpus is 500 crore, 750 minus 250, or 50%.
• Need a minimum of INR 10 lacs.

Are SIFs Worth Exploring?

From a strategy flexibility point, AIFs score over SIFs. AIFs are allowed gross exposure up to 200% and can short up to 200% of their corpus, whereas SIFs are allowed gross exposure of 100% and can short only up to 25%.

However, unlike AIFs, the tax structure applicable to SIFs is the same as traditional mutual funds. And that does make them attractive for 2 reasons:

• SIFs are subject to capital gains tax, which is significantly lower than the highest rate applicable to most AIFs.
• Investors pay tax only when they exit the SIF, not when the fund churns its portfolio. This prevents tax leakage and allows funds to compound on a larger base, a fundamental advantage that gets accentuated in strategies that could see high portfolio churn.

(F) To Hedge or Not to Hedge?

Should one invest in hedge funds? Investors with larger sums have the option to invest in both AIFs, minimum 1 crore, and SIFs, minimum 10 lacs. Those with lesser sums can invest in SIFs. There is indeed a case to consider them. The world is going through an unprecedented phase of geo-political shifts, expanding balance sheets of Central Banks, and market volatility. Hedge funds offer a very different risk-reward profile compared to traditional assets, and a certain allocation can reduce the volatility of an overall portfolio.

However, this should only be considered after the risks and strategies are thoroughly understood. While that is true for any investment, it is truer for hedge funds. Given that no two hedge funds are the same, the jargon is complex, and the Indian wealth management industry continues to be dominated by a sales-led culture, investors should be cautious. We believe the incentive structures of much of the industry are not always aligned with the investor, which can lead to poor decisions.

Please note that the above note is for general guidance. For specific clarity and details, please reach out for a detailed discussion before making any formal moves. It is crucial that theories and concepts are properly vetted from the perspective of an investor's suitability and appropriateness before any investment decision is made.