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The Alter-NATIVE series How hedge fund managers generate alpha?

How hedge fund managers generate alpha?

Hedge fund manager’s arsenal are flexibility, shorting and the use of leverage.
Nalin Moniz Aug 21, 2017

Category-III AIFs are often synonymous with hedge funds, but in practice there are two kinds of Category-III funds. First, there are long only funds where the AIF platform is being used to run thematic long only ideas or to pool money with the ease of a mutual fund but with lighter restrictions. Second, there are true hedge funds. The first category of funds have similar risk and return characteristics to PMS portfolios or in some cases thematic mutual funds so we will not delve into them in depth. Instead we will focus on the second category of funds. To be sure, it is possible to offer some hedge fund-light strategies in a mutual fund or PMS avatar but the lack of leverage and tighter restrictions make them easier to understand.

A basic premise of any alternative investment is that it has to 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  and funds that are an alternative to fixed income in a client’s asset allocation. Equity alternatives offer similar or higher upside than an equity mutual fund but with a lot lower drawdown and risk while fixed income alternatives 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. 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 constrained to have at least 65% of their AUM in equities at all times 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 209 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.

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 stringent guidelines on offsetting, the calculation of leverage, risk management practices and reporting. 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 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.

Nalin Moniz is the Chief Investment Officer – Alternative Equity, Edelweiss Global Asset Management

Past performance is not an indication of future performance. Investments in the securities market are subject to market risk.

Please read the Private Placement Memorandum carefully before investing.

 

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