The Long & Short of Hedge Funds

The world of finance thrives on complexity, and few corners embody this more than the realm of hedge funds.

The Indian hedge fund industry up until now, was accessible only via AIFs (Alternative Investment Fund) and due to the minimum threshold of AIFs, was accessible only to investors with deeper pockets. That is set to change. With the regulator having relaxed the norms, a much larger base of investors can now access these funds. An all-together new category of funds has been created – SIFs (Specialized Investment Fund), with a much lower threshold.

Two asset management companies (AMCs) have already launched their schemes, and many more are in the process.

I would, however, hesitate to invest in these funds (either through AIFs or SIFs) without a thorough understanding of their risk-return trade-offs. They employ complex strategies which make them fundamentally different from the conventional equity and debt funds. Having said that, these funds can add an important dimension to your investment portfolio. And even more so, in a changing world order, where financial market volatility is expected to increase.

Hence, I decided to put this detailed note together. I hope it gives you a clearer understanding of these funds, the complex strategies they employ, and the complex jargons that are part & parcel.

(A)Breaking down the jargon:

The word ‘hedge’ comes from the Old English word hecg, meaning a fence or barrier. In finance, to hedge is to take actions to reduce potential losses, much like a hedge protects a garden or field from unwanted elements.

Hedge funds are named ‘hedge’ funds because their original purpose was to hedge, or protect, investments from market risk by using both long and short* positions to offset potential losses, like a physical hedge protecting a property. While modern hedge funds employ a broader range of strategies and can be very risky, the name reflects this core concept of risk mitigation and protection through simultaneous betting on both rising and falling market prices.

*Long, in financial market parlance, means buying something – a stock, a currency, a commodity. You stand to gain if the price goes up. Short, in market parlance, means selling something. You gain if the price falls.

The first hedge fund was founded by Alfred Winslow Jones in the mid-20th century. His strategy involved taking both long (betting on price increases) and short (betting on price decreases) positions in stocks to ‘hedge’ against overall market downturns. By going long on undervalued companies and short on overvalued ones, Jones aimed to insulate the fund from market volatility while still capturing profits from individual stock picks. This dual approach was key to the ‘hedging’ in the fund’s name.

Over time, the hedge fund industry has evolved beyond simple hedging strategies. Today, hedge funds employ a variety of complex, and often highly risky, investment strategies, including leveraging capital and trading across different asset classes, such as equity, fixed income, currencies, commodities.

Despite the expansion of strategies, the term ‘hedge fund’ remains, still implying the potential for risk management, although the level of actual hedging can vary significantly between funds.

This also brings us to the other meaning of the word ‘hedge’ – which is to avoid giving a direct answer to a question. Over the years, in the many conversations I have had with clients while positioning a hedge fund in their portfolio, I have noticed a somewhat bewildered expression on their faces. The reason being that the risk-reward equation of these strategies is not as straight forward as say investing in stocks or bonds. And a yes/no answer to a question might not be only difficult, but also not warranted.

(B) Demystifying Long-Short strategies:

At the heart of most (not necessarily all) hedge funds lie the two words long & short. Unlike traditional mutual funds that simply buy and hold, long-short funds engage in both going long on assets they believe will rise in value and going short on those anticipated to fall. This creates a fascinating dynamic:

You might have heard of or invested in arbitrage funds as means of temporarily deploying your short-term surpluses. They are, in general, considered safe. The fund takes a simultaneous long position on the stock of Company A (say 100 million) and a short position on the futures of Company A (for the same amount). Since most times, the futures* of an underlying stock trade at a premium to the stock, the fund pockets the difference, irrespective of which way the price moves. While there are no perfect hedges in a practical sense, arbitrage funds are closest to it since the fund has gone both long & short on the same company, for the same amount. And in the process, pocketed the small difference between stock & future price of that company. ^[1]

*Futures – when you buy a stock (shares), you make full payment and take delivery of it in your demat account. However, instead of making full payment, you can buy a future of the same stock and only pay a fraction (called as margin) but you have an obligation (contract) to either square off (sell) or make the balance payment and take delivery of the stock (in your demat account) after a certain time has elapsed. Most popular Future contracts in India are for 1 month.

Now, let us start to complicate the equation.

Imagine a fund which is investing INR 100 million in Company A, expecting its value to rise, and simultaneously taking a short position of INR 100 million in its competitor, Company B, anticipating its value to fall. The fund manager is betting that Company A will do better than Company B in terms of stock performance. ^[2]

Best case scenario: Company A stock goes up and Company B stock goes down. Fund makes money on both positions.

Good case: Company A stock goes up more than Company B stock OR Company A stock falls less than Company B. Fund gains the differential.

Bad case: Company A stock goes up less than Company B stock OR Company A falls more than Company B. Fund loses the differential.

Worst Case: Company B stock goes up and Company A goes down. Fund loses money on both positions.

Usually, when both stocks are in the same sector (for example banking), and if both banks are, in general doing well but in the short-term A is expected to do better than B (due to better quarterly results or some announcements), then the likely anticipated scenario is the good case. Since stocks & sectors also get impacted by overall market conditions, it is likely that overall markets are in correction mode (due to say Trump tariffs), and both Company A and B stocks go down. The good case scenario is however agnostic to market conditions and if the Fund Managers gets the call right, the fund will gain the differential.

The above can also apply to stocks which might not be in same sector but either due to their businesses being linked to a common theme and/or their past stock movement data, they are highly corelated. So, if the market rises or falls, both stocks will likely move in tandem, offsetting each other’s impact. However, if one stock outperforms the other due to company-specific news or events, the fund stands to profit from this unique, non-market related risk.

These kinds of trades are usually bucketed under what is referred to as market-neutral strategies and the specific name given to the trade is pair trades – where the fund identifies two securities whose prices should theoretically move in lockstep but have temporarily deviated. By taking a long position in the undervalued security and a short position in the overvalued one, the fund capitalizes on this mispricing, aiming to profit when the prices eventually converge.

Complicating it further - In the above example, I looked at two stocks in the same sector or stocks which were highly co-related. What if the stocks were not in the same sector and / or there is no co-relation between them? For example – going long on Banking stock A (Banking index) and going short on a Tech stock B (Tech Index). The fund manager believes that Banking stock A is a good stock to buy, as it is expected to appreciate. A traditional mutual fund will stick to only such decisions.

However, a long-short fund will also want to profit by shorting companies which it believes are expected to depreciate (due to poor management, sector not in favor etc.). In the best of market conditions, there always are Companies which are expected to remain flat or fall. They therefore focus on identifying stocks which are expected to do well and stocks which are expected to lag or fall in value.

The above logic can also be applied to asset classes. Think of it. If you expect equity markets to do poorly and expect Gold to do well? You could then short an equity index (say Nifty-50) and go long on Gold. ^[3]

Such trades are no longer market neutral. As the prices are not anticipated to move in tandem. In fact, the fund manager is taking a deliberate call that the long position (be it banking stock, or the banking index or Gold) is expected to go up AND the short position (be it tech stock, or the tech index or Nifty-50) is expected to go down.

Now, let us imagine a fund which has a total corpus of INR 1000 crores. It is bullish on Gold and bearish on Nifty-50. And it decides to buy INR 500 crore worth of Gold and the remaining INR 500 crore to short Nifty-50. In this case, the fund is only using the resources it has.

What if it extends itself? That is, it borrows or what is known as leverage. And then goes long on Gold for an amount of INR 1000 cr and shorts Nifty-50 for an equal amount. ^[4]

Leverage brings a whole new dimension to the risk-reward equation of a hedge fund employing long-short strategies. If the decision to use leverage goes in favour of the fund manager, they become the talk of the town. If it goes against, it can lead to closure of the fund and investors losing a lot or all their capital. Over-extending one’s resources might appear irresponsible, however in the world of hedge funds, it won’t be wrong to say that over-extending (or leverage) is what defines them.

(C) Understanding of Net Exposure vs. Gross Exposure:

The distinction between net and gross exposure is crucial. Gross exposure is the sum of long & short, whereas net position is net of long & short.

In general (but not necessarily – please see the table on next page), a low net exposure means the fund is less affected by overall market changes, minimizing risk. A high net exposure makes the fund more sensitive to market movements, amplifying both gains and losses. On the other hand, the gross exposure tells you how much leverage the manager is employing OR if the manager is over-extending the resources (going beyond the total sum of money given by their investors).

In simpler terms, long-short hedge funds aim to balance their bets by going both long and short on different stocks, indices, asset classes, and the difference between these positions (net exposure) determines how much they are affected by market fluctuations.

The Net position in all the above is Zero. However, implications, as mentioned under the ‘Remarks’ column are very different. And it is very crucial to understand the implications.

Likewise, the gross position in 1 (2nd instance) is same as in 4.

However, the big difference is that the fund manager is shorting the futures of the same stock and it is a near-perfect hedge*, whereas in (4) if the asset class where the fund has gone long falls by say 50% and the asset class where the fund has gone short, goes up by 50% - the fund will lose all its capital. For example, if the total corpus (total client money) is INR 100, and fund takes a long position on Asset Class A for INR 100 and short position of Asset Class B for INR 100:

There have been several such instances in global history. Long Term Capital Management (LTCM) is often quoted as its collapse nearly caused a global financial meltdown.

www.investopedia.com/terms/l/longtermcapital.asp

More recently, in January’24 Singapore-based Asia Genesis Asset Management** liquidated its hedge fund after a ‘significant and unprecedented drawdown’ following missteps in Chinese and Japanese bets.

*Important to mention that there is no perfect hedge even though the history of arbitrage funds in India suggest that the risk is with respect to variability in returns and not on the capital.

**The Asia Genesis Macro Fund lost 18.8% in the first weeks of January, Chief Investment Officer Chua Soon Hock said in a letter to investors (as reported by Reuters). He decided to close the fund to prevent further loss and return money.

The fund, which hedge fund veteran Chua launched in 2020, was managing about $300 million. The closure came amid an unprecedented stock rout in China and sustained rally in Japan. As per Reuters, the letter mentioned that they made big mistakes in the sharp Nikkei and Hong Kong moves which went in opposite directions and that he has reached the stage whereby his confidence as a trader is lost.

The fund increased long positions in Hong Kong and China and was short in Japan, based on the prediction that China would outperform Japan in 2024 after being sold off for the past three years, whereas Japan would be muted after a 30% rally in 2023. Interestingly (and sadly for the fund) had this trade been done in 2025 beginning, while Japanese markets continue to do well, Chinese markets have also had a good rally. So, the fund would have lost money on their short position in Japanese markets but made money on China. IN 2024, they lost money on both trades.

As is evident, the long-short strategies used by hedge funds, operate on an entire spectrum. While at one end, there are arbitrage funds (which are not even referred to as hedge funds), at the other end there are funds which employ leverage. And the leverage is not restricted to two times as mentioned in the example above. It can be lot higher. Things get complicated when funds use Options as a strategy. Options is another instrument (besides futures – though they are even more complex) which allows an investor to bet on markets with limited capital of their own.

And hence, it is very crucial to understand the personality of Gross & Net Exposures, while evaluating long-short strategies. As two funds with the same gross exposures or net exposures can have very different risk-reward profiles. Understanding the Risk and Reward is the key as only then you can pick a fund which serves your requirement and importantly, matches your personality.

Also important is to understand the DNA of the Institution involved, especially with respect to its risk management policies. Undoubtedly hedge funds are helmed by some of the sharpest minds in the world of investments. This strength is also their biggest weakness and hence it is important to assess their temperament (EQ) as managing risks and yet generating good returns makes their job challenging & stressful.

(D) Other strategies (besides Long Short) used by Hedge Funds:

While long-short strategies lie at the heart of hedge funds (and hence hedge funds are also sometimes referred to or named as long-short funds), there are other several distinct strategies and approaches. However, before I get into those, it will be good to understand another aspect – which is the fund management style:

Quantitative vs Discretionary

A Quantitative style hedge fund relies on systematic, data-driven methods, such as mathematical models, statistical techniques, AI & machine learning to make investment decisions. As against this, a Discretionary fund relies on human skillset and acumen. While the humans involved might use quantitative models to aid their decision making, they take the call. Whereas in a typical quantitative fund, humans are involved in building the model, but the model dictates the buying/selling decisions.

Discretionary-styled hedge funds are identified by their fund manager, many of whom have legendary status. Quantitative styled hedge funds are less known by the personalities at the helm. There are exceptions like Renaissance Tech LLC started by Jim (James) Simons.

Some might start as discretionary style, but over time codify their style. For example, the legendary Ray Dalio started as a global macro investor, focusing on big picture economic themes. Over time, his discretionary views were codified into systematic, fundamental macro programs, which involved writing down rules and back-testing them. His hedge fund Bridgewater Associates is now one of the largest quant-styled hedge funds.

Following are some of the prominent strategies used by hedge funds, besides Long Short:

Event-driven strategies capitalize on corporate events such as mergers, acquisitions, buy-backs. These strategies are also known as special situations. Usually these strategies form part of many hedge funds as a sub-strategy, and not the primary strategy.

Option strategies involve active trading strategies in index and stock options. There are multiple options strategies at work. I have mentioned a few* though I am not explaining how they work. As that will require a separate note altogether. Options trading is an entire industry attracting top talent and the brightest minds. The vocabulary of an options trader will be like learning a new language all together. Words like Delta, Gamma, Theta, Vega are par for course. Hence, hedge funds which employ Options strategies are like a black box to most investors and have prevented clear-headed individuals from investing in such funds, OR the invest a very small proportion of their funds. The logic being that they’d rather stick to investing in funds which they have a basic understanding of what the fund does.

* To name a few options strategies – options spreads, calendar spreads, volatility trading, index dispersions.

Global Macro funds which involve investing based on macroeconomic trends, such as interest rates or currency fluctuations. The holdings are often positioned around a specific result of international economic or political issues. These funds can take both long & short positions. An oft-quoted example of a global macro fund is George Soros’s Quantum Fund, particularly for his 1992 trade that ‘broke the Bank of England’ by betting against the British Pound. They initiated a massive ‘short’ betting on a significant devaluation of the Pound.

Absolute Return Funds

These funds aim to generate a profit in any market condition, whether up or down, by using strategies like long & short, event-driven, options trading, rather than trying to beat a market benchmark. They aim to produce consistent, positive returns regardless of overall market performance or direction.

The absolute return funds are very popular in India and command a large (if not the largest) share of investor wallet. They usually get pitched as an alternative to debt / fixed income funds, as on a post-fee, post-tax basis, they have provided a 2-3% alpha over debt funds. However, their track records have not been consistent, and many funds after having a good run have gone through a lean phase. A prominent fund after a stellar run went through a bad patch (they were sill giving positive returns in this period but much lower than their own past performance) decided to stop operations. Investors need to keep in mind that absolute return funds have a very different characteristic as compared to traditional fixed income products and is not a like to like substitute.

These funds rely significantly on options trading. The options market has however seen major regulatory interventions in recent past. The regulator has expressed concern due to the heightened retail participation in options trading and has taken steps to curb excessive speculation. This could be one reason why absolute return funds have been delivering inconsistent performance.

Given their reliance on options trading, it is very difficult for most investors to grasp the nuances of how these funds generate absolute returns. That gives these funds the characteristic of a black box, with the investor taking a leap of faith on their advisor and/or the hedge fund.

Unlike absolute return funds, the traditional hedge funds rely more on their ability to identity undervalued and overvalued stocks, sectors, asset classes, and hence are easier to comprehend. They might still not be easy to replicate as the ability to bet on both sides of the market is not only rare, but it is not easy to do so consistently. It requires a very calm head on the fund manager’s shoulders. Burnout can be high.

Important to remember that not all hedge funds are created equal. And while investors must be mindful of what exactly they are signing up for, they no longer need to be on the lookout for the proverbial ‘wolves of Wall Street’ within the hedge fund world. At least in India. As mentioned above, the market regulator has been quite mindful of the risks involved and has hence, until recently kept the minimum threshold high (minimum 1 cr) and restricted the gross exposure to 200% or 2 times the funds corpus. This is through vehicles known as AIFs (Alternate Investment Funds). They have only recently opened this space (that is where SIFs come in) but with very tightly controlled parameters.

(E) Specialized Investment Funds (SIF)

These are like your traditional mutual funds with a twist. And an interesting one. Which makes them special.

Traditional mutual funds:

• buy a stock or a bond or a commodity (gold/silver) or real estate units (REITs), with the expectation that what they have bought will go up in value. And at some stage, they sell what they have bought.
• only deploy the funds provided to them by investors. They cannot use leverage. They do not short or use any kind of derivatives, except for arbitrage strategies (as explained on page 2).
• their gross & net exposure will be the same and will be equal to the corpus of the fund.
• need a minimum of INR 5,000

Specialized Investment Funds:

• besides buying a stock or a bond or a commodity (gold/silver) or real estate units (REITs), can also short any of them, up to 25% of funds corpus.
• only deploy the funds provided to them by investors. Same as traditional. They cannot use leverage. However, they can short and can use derivatives, up to 25% of the fund’s corpus.
• their gross exposure cannot exceed 100% - hence equal to the corpus of the fund. However, their net exposure can be as low as 50%. Not lower. Assume a SIF has a corpus of 1000 crores. The fund has gone Long for an amount of 750 cr (it can go up to 1000 cr). The fund is allowed to go Short for up to 250 cr (25% of corpus). Hence the net corpus is 500 cr (750 – 250) or 50%. It cannot be below this number.
• need a minimum of INR 10 lacs.

Is this a big deal?

Compared to AIFs (mentioned in previous page), it is not. AIFs are allowed gross exposure up to 200% as compared to SIFs at only 100%. AIFs can short (technically) up to 2 times or 200% as compared to SIFs which are allowed to short only up to 25%.

However, unlike AIFs, the tax structure applicable to SIFs is the same as traditional mutual funds. And that is a big deal for 2 reasons:

• The tax structure applicable to hedge funds which operate under an AIF is at the highest rate (for most funds) and that takes away a large component of the return. Whereas SIFs (equity and hybrid) will be subject to capital gains tax at 12.5% if held for 1 / 2 years.
• Investor must pay the tax every time an AIF churns its’ portfolio. There is no tax incidence either on the investor or the fund in case of a SIF. Investor pays tax only, as and when, they exit the fund. Now this has been a fundamental advantage of mutual funds over AIFs and PMSs, but the advantage gets accentuated in SIFs which could see far higher portfolio churn. The tax leakage on churn implies your funds are getting compounded on a lower base.

(F) To hedge or not to hedge?

Should one invest in hedge funds? Investors with larger sums have the option to invest in both AIFs (min 1 cr) and SIFs (min 10 lacs). Those with lesser sums can invest in SIFs.

There is indeed a case to consider investing in hedge funds. The world, as we know it, is going through an unprecedented phase – be it the ever-changing geo-politics in a multi-polar world, question marks on dollars hegemony, an all-time high US debt and the related tariff wars, earnings slowdown and high valuations of Indian markets. Hedge funds offer a very different risk-reward profile as compared to traditional stocks or bonds and a certain allocation can reduce volatility of your overall portfolio.

However, only and only after you have understood the risk-reward. While that is true for any investment, it is truer for hedge funds. Given that no two hedge funds are the same, the jargons are far more complex, and very importantly, the Indian wealth management industry continues to be dominated by a sales-led, commission-driven culture. That worries me as the incentive structures of most of the industry is not aligned to the investor & can lead to poor investment decisions.

Two Asset Management Companies (AMCs) – Edelweiss and SBI – have announced launch of a specific SIF scheme in the hybrid long-short category. DSP and Mirae – have indicated their intent. Many more are expected to follow. I have shared relevant links below.

Please note that the above note is for general guidance. For specific clarity, details, please reach out to me or the team before any formal moves are made by you or your organization. We’d like to ensure, as part of our internal QC & audit process, that theories, concepts, ideas are properly vetted from the investors’ suitability & appropriateness point before any investment decision is made.