Nifty has crossed 10,000, markets are hitting new highs, PE multiples have marched upwards of 25x. Some are worried about whether a crash is imminent, others believe that we are nowhere in bubble zone, and many are just too confused and therefore remain on the sidelines, caught between fear and greed. Equity fund managers have strong convictions on merits of individual stocks - and their convictions may be well placed - but they are powerless to turn the tide of markets. What if you were able to leverage a fund manager's convictions in stocks but cut out market risk completely, to try and make money on these convictions - irrespective of the way markets go? Is that at all possible? Yes indeed - and such products are red hot the world over. Welcome to the world of market neutral strategies or long/short investing.

Long/short equity is an investing strategy of taking long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. A long/short equity strategy seeks to minimize market exposure, while profiting from stock gains in the long positions and price declines in the short positions. Although this may not always be the case, the strategy would be profitable on a net basis as long as the long positions generate more profit than the short positions, or the other way around. The long/short equity strategy is popular with hedge funds, many of which employ a market-neutral strategy where the dollar amounts of the long and short positions are equal. (Investopedia)

What is 'long' and what is 'short'?

Taking a long position means that one actually buys a stock in the belief that its value would appreciate over time, usually a long time. If the stock goes up there is profit. Alternatively, a short position means that one borrows a stock that one does not own. The idea is to sell it, in the belief that its value will go down. Thus having sold at a higher price one can realise a profit by buying it back cheaply as the stock's value go down and restore the shares to the lender.

The long/short strategy

Lets take a hypothetical example. Lets say you keenly track the banking space, in particular, private sector banks. Lets say, after your thorough research, you are convinced that Kotak Bank has much better prospects than Axis Bank and believe that its share price should do significantly better among the two. You are happy to bet on Kotak Bank outperforming Axis Bank, but unwilling to bet on where markets will head in the next 1 year, and therefore how private sector banks as a group will perform in the next 1 year.

You can set up a long/short strategy by taking a long position of say Rs. 10 lakhs in Kotak Bank and simultaneously a short position in Axis Bank, also for Rs. 10 lakhs. Here are three scenarios of how your long/short strategy can play out:

Case I is where markets go up and private banks go up 10%. Your alpha call is correct - Kotak Bank outperforms Axis Bank on the way up. You land up making money on your long position in Kotak Bank, you lose money in your short position in Axis Bank, but you are net in the money - to the exact amount that represents the difference in performance between Kotak Bank and Axis Bank - ie, you earn pure alpha and give up the beta.

Case II is where markets go down, but your alpha call is still right in the sense that Kotak Bank goes down much less than Axis Bank. Here again, despite the fact that markets went down, your net return is positive - and is equal to the alpha of Kotak Bank over Axis Bank. You earn the alpha and don't get hit by the beta of markets going down.

In cases I and II, you made money irrespective of how markets went - up or down - you received the reward for your alpha call. That sounds too good to be true - so, what's the catch? The catch is in Case III - where your alpha call turns out to be wrong. Your bet was that Kotak Bank will outperform Axis Bank - but if the opposite happens, you land up losing money, even if both banks go up in a rising market.

130/30 funds

Long/short strategies are widely used by hedge funds the world over, including in the alternate investments space in India. You can have long/short strategies like the example above where you have strong views on one stock in a sector significantly outperforming the other. You can also put together a long/short strategy with 5-10 of your high conviction bets across sectors as long positions, and the market as a short position in the form of shorting the index. This allows you to extract pure alpha irrespective of how markets go, if you believe your 5-10 favoured picks will outperform the market.

In US, UK and other developed markets, long/short strategies have been adapted into mutual fund products in the form of 130/30 strategies. The total long positions will be equal to 130% of AuM and total short positions will equal 30% of AuM, giving a net long position equal to 100% of AuM. The strategy here is that 100% of AuM is playing for both alpha and beta and then another 30% on the plus side and 30% on the minus side is playing for an incremental alpha that gets added onto overall fund performance.

The long -short strategy has become popular, perhaps because of its intuitive appeal of placing confidence in a fund manager's convictions while insulating against the market. This strategy allows investors flexibility, innovate financial solutions and to diversify and enhance their portfolios. However the strategy is not without risks. In general, hedge funds, unlike mutual funds, are not very liquid. It may be difficult to sell shares whenever one wants to. For investors, such strategies come with high fees. They also face some specific risks. For example, the investment manager must be able to correctly forecast the relative performances of two different stocks, which is difficult to say the least. It can also suffer from what is known as 'beta mismatch'. This means that when the market falls sharply, long positions could lose more than short positions. Yet the long-short strategy helps investors to maximise returns in difficult market conditions. A key consideration would be the ability of portfolio managers to evaluate risks and find sound opportunities to invest.

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