Unlike mutual funds, which have well-defined investment strategies, hedge fund managers (or category III alternative investment fund managers) enjoy more flexibility when it comes to investing. It is safe to say that no two hedge funds will be exactly alike. However, a few strategies are more prevalent.
In the part one of the series, we look at three common hedge fund strategies used globally:
1. Long-short strategy
This is the oldest and most common hedge fund strategy. Fund managers following this strategy buy a stock, which is undervalued (stock A) and sell a stock, which is overvalued (stock B). By doing this the fund manager makes money irrespective of how the market moves so long as price of stock A is higher than price of stock B. The idea is that, the fund manager researches both stocks to buy and stocks to avoid. By betting on both, the fund manager reduces market risk. At the same time, he increases his potential return if his investment rationale turns out to be correct that is he gains from both the price increase in stock A (long investment) and price decrease in stock B (short investment).
Edelweiss, Avendus and DSP pioneered this strategy in India. SEBI has permitted category III AIFs more flexibility in terms of use of derivatives and 2x leverage.
2. Long-Only strategy
Long-only hedge funds invest in businesses with a potential for growth. The strategy is also quite popular among mutual funds. However, unlike MFs, AIFs have no restrictions in terms of market capitalisation or investment concentration. This allows hedge fund managers to take bolder bets than mutual funds. The logic is equities being a risky asset class, high-risk can deliver high return. However, there is no guarantee on when the return will be realised. Another factor in favour of this category is that equities over a long time tend to move up, so it is challenging to make money by short selling.
This is a common category III AIF strategy in India. Industry sources say that 45 out of the 85 category III players in India are long only boutiques.
3. Short-Only
This is for the bears in the market. Fund managers following the short-only strategies are on a lookout for overvalued stocks. They try to unearth likely troubles in a company and bet against it. Short-only strategy involves extensive balance sheet analysis, meetings with competitors and suppliers to identify if there is any wrongdoing or fraud. These funds are risky as they bet against the inherent tendency of equities to rise. However, the gains can be monumental if they uncover something like an accounting fraud. For e.g. if a hedge fund manager had short-sold Satyam in 2008-09, the fund’s investors would have earned phenomenal returns as the stock price dropped from around Rs. 542 per share to Rs. 58 per share.