Home Alternative Investments Are market-neutral funds the answer to a bear market in India?

Are market-neutral funds the answer to a bear market in India?

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Avendus Capital has recently launched a Category III Alternative Investment Fund (AIF)—Avendus Market Neutral Fund. Market neutral funds are funds that go both long and short on stocks, thereby reducing or eliminating market risk.

A number of AIFs which partially hedge their portfolio already exist but very few funds in India seek to eliminate it altogether. Such a strategy can outperform a simple ‘buy and hold’ or ‘long only’ strategy in a down trending market. The Nifty is down 11% since the start of 2022. However, experts suggest buying into such funds only after they establish a track record. Since such funds are AIFs, they have a minimum ticket size of 1 crore.

Avendus Market Neutral Fund, which seeks to fully eliminate market risk, will be allowed to deviate by only 10% from a 100% hedged position (long and short positions of equal magnitude). It will do this using stock futures and will target primarily the 100 largest listed companies. Avendus Capital already has one such offering —Avendus Absolute Return Fund. However, the new scheme will use a quant-based strategy and target post- tax and post-expernse returns of 8-11%.

“There are two kinds of risks in equity investing. The first is market risk, which is the risk of the entire market moving up or down. The second is stock selection risk, which is the risk of selecting the wrong stocks. Our model will eliminate the former (market risk).We will use a combination of momentum, mean reversion and factor-based investing to determine which stocks to go long on and which to short,” said Vaibhav Sanghavi, co-CEO, Avendus Capital Public Markets Alternate Strategies. According to Sanghvi, such varied strategies will reduce the risk of making the wrong trades. It will be open ended with an exit load of up to a 6-month holding period. For an investment of 1 crore to 5 crore, the fund will have a management fee of 1% and performance fees of 25% above a hurdle of 10%. For example, if your corpus of 1 crore makes a return of 20 lakh, Avendus will charge a management fee of 1 lakh. It will also charge a performance fee on the return generated above 10%. This return comes to 9 lakh (after factoring in the management fee) and hence the performance fee will be 2.25 lakh.

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In India, Category III AIFs—some of which hedge part of their exposure—have so far shied away from being fully market neutral. A major reason for this is the tax treatment of such funds. “Category III AIFs have to deduct 42.7% tax at source on trading income which is regarded as income from business and profession. This eats into post-tax returns in a big way. That is why market neutral funds have not come up in a big way so far in India,” said Nalin Moniz, chief investment officer, Alternative Equity, Edelweiss Asset Management Ltd.

The Avendus Market Neutral Fund is targeting a post tax return of 8-11%. This translates to a pre-tax return of 19-26% if you are in the highest tax bracket. For those in the 30% tax bracket, the post-tax return will be higher.

A market neutral fund can outperform a traditional long-only equity fund in a bear market or a relatively range-bound market. However, investors should take note of the taxes. Stock selection risk or the risk of the fund manager picking the wrong stocks for going long and going short, also remains on the table. “For all algo and quant based strategies, we usually look at a minimum 1 year and ideally 2 year actual portfolio data. Backtested returns have their own dilligence challenges,” said Munish Randev, founder and CEO, Cervin Family Office.

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