Wealth Guide: Advantages of Long-Short fund in a volatile market

The “asymmetric return” profile makes a long-short fund one of the best platforms to compound wealth for the long term.

Basically, it lowers the risk of capital losses and opens-up upside opportunities to make an equity-like returns.

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Ajay Vaswani, Senior Vice President at ITI Long Short Equity Fund decodes the strategy of a long-short fund and how it minimize risks amid volatility:

Negative Real Returns:

Today, investors in India and elsewhere are facing dual challenges. The first challenge is negative real returns in fixed income.

For instance, for an investor, a fixed deposit investment in say -- State Bank of India (SBI) generates a pre-tax annual return of around 4.5% when inflation is around 5-6%, translating into a negative real rate of return.

While the purpose of investing is to maintain or grow one’s purchasing power, a negative real return means an investor is actually losing purchasing power by investing in fixed income.

Even though the rate-setting committee of the Reserve Bank of India (RBI) might hike policy rates by a few basis points in its forthcoming meetings, the scenario is not going to change much for fixed income investors as inflation looks entrenched. This makes investing in fixed income less appealing.

More, the value of the world’s stock of negative-yielding debt had ballooned to more than $16 trillion. This phenomenon of low or negative real returns has been triggered by the policy actions of the world’s leading central banks led by the US Fed.  

They have pumped in a wall of money into the system and kept interest rates at multi-year lows ostensibly to counter the pandemic induced slowdown in the economy.

This policy called “Quantitative Easing” (or QE) was instrumental in pumping up the valuations of several assets including equities.

Stretched Equity Valuations:

The second challenge facing the investors is stretched equity market valuations and risks. Global markets including Indian markets were trending at all-time highs till recently. The valuation of Indian equities was also close to its historic high levels. Sentiments of the market participants were also ebullient.

It is an undisputed fact that the primary reason for the surge in equity valuations was the unleashing of liquidity by major central bankers across the world and the expansionary fiscal policy by respective governments.

The flip side of this policy is that any changes in market expectations about shrinking in liquidity levels will drag down equity prices from their all-time high levels.

While it is difficult to say how far this enthusiasm will take markets on its upcycle what is clear is that from here on the major theme for markets will be on the unwinding of these quantitative easing measures by major central banks.

This will certainly trigger increased volatility and sharp declines in equity markets.

Shift To Hedge Funds:

Given these challenges, large and sophisticated investors are shifting to a hedge fund or a long-short equity fund.  

While there are several variants of long-short strategy funds available in the market, the primary objective of a pure-play long-short fund essentially is to achieve the following:  

a. In case of a market decline, protect the downside
b. Generate an equity-type return on upsides; and
c. Over a full equity market cycle, beat the equity markets; the result is achieved with much lower risk and much lower volatility for the investor.

In essence, this “asymmetric return” profile makes a long-short fund one of the best platforms to compound wealth for the long term.

Basically, it lowers the risk of capital losses and opens-up upside opportunities to make equity-like returns.

Thus, in volatile markets, it is critical for investors to understand why downside protection is important and how does it add value to equity investing in the long term.

Remember Warren Buffett’s first principle of investing: “Rule No 1– Don’t lose money, Rule No 2 – Never forget Rule No 1.” The mathematics of declines means “you win, by not losing”.

(Disclaimer: The views/suggestions/advice expressed here in this article are solely by investment experts. Zee Business suggests its readers to consult with their investment advisers before making any financial decision.)