Equity long-short funds promise better risk-reward than traditional equity products

Mutual funds are on the verge of becoming a household name in India when it comes to investing in equities. Young investors have been exploring the world of investments with an open mind compared to previous generations. Capital market regulator- Securities & Exchange Board of India, has approved the launch of specialised investment funds (SIF) to allow mutual funds to offer evolved investment strategies to the public at large. Under this new category of product, Equity Long Short Fund is the first type of product. Let’s look at this in detail and how it is expected to work for the investor.

To put it simply, Equity Long Short Fund (ELSF) is a flexi-cap equity fund with a provision to go short. Let’s elaborate further. A flexi-cap fund allows a fund manager to buy shares of companies of all sizes – large cap, mid-cap, and small-cap, as per his discretion. There are no internal thresholds in terms of exposure to each of these three segments. The ELSF will allow the fund manager to buy shares of companies of all sizes. However, the twist is that the fund manager can also short sell equities using derivative instruments such as futures and options.

A flexi-cap fund is a long-only product, whereas ELSF is a long-short product, in industry parlance. An ELSF must have a minimum of 80% of the money invested in equities. An ELSF’s short positions are capped at 25% of its assets under management of the scheme. This should work wonderfully for investors looking for improved risk-reward compared to a long-only equity product. A long-only product, a flexi-cap fund, falls in line with the falling market. A fund manager of a flexi-cap fund can allocate some money to defensive stocks in an attempt to contain downside. But he or she can in no way benefit from the falling markets. An ELSF, however, allows a fund manager to short stocks.

For beginners, shorting a stock means selling a stock that one does not own, with the intention to buy it back at a later date using derivative instruments on that stock. At any given moment of time, the fund manager can buy stocks on which he has a constructive view, and short-sell those stocks which he expects to fall. In a volatile market, the 25% short positions can effectively make money for the investors.

ELSF thus can not only contain downside for the investor but also identify weak stocks and make money by short selling them when the markets are in a turmoil. In a rising market, if a fund manager bets on a few short selling opportunities, and the stocks do not fall as much, then the returns may appear muted compared to a long-only flexi-cap fund. Investors can expect a relatively smoother ride from an ELSF as compared to a flexi-cap long-only mutual fund scheme.

ELSF are actively managed products. The role of a fund manager is vital in the working of an ELSF. It will be interesting to know the expense ratio of these schemes. Also, short-selling may involve increased costs on account of roll-over, compared to a long only product, impacting post expenses returns offered by ELSF We may see wide variations in returns offered by various ELSFs.

Since this is a long-short strategy a fund manager needs to be given long enough time to execute his strategy. Ideally one market cycle – or say a period of five years is the minimum holding period for investors considering an investment in these schemes. Minimum investments in these schemes stand at Rs 10 lakh. That is a good entry point. This ensures that most first time investors will stay out. But this may suit the needs of investors who have been investing in mutual fund schemes but are finding it difficult to invest in a portfolio management service (AIF) or alternative investment fund that ask for minimum investment of Rs 50 lakh and Rs 1 crore respectively.

Another benefit of investing in an ELSF is the equity taxation the investor enjoys. Gains booked after holding ELSF for a minimum period of one year are considered long term capital gains and taxed at the rate of 12.5% which is concessional for individuals in higher income slabs.

Investors should first build their mutual fund portfolios geared for their financial goals. As they get acquainted with the long-term investment philosophy and the market behaviour, they may find ELSF suitable if they are keen on an equity product that offers less volatile payoffs in a tax-efficient manner over the long term.

(Anup Bhaiya is Founder of Money Honey Financial Service)_

Disclaimer: This report is prepared in his personal capacity and neither the Author nor Money Honey Financial Services Pvt Ltd assumes any responsibility or liability for any error or omission in the content of the article. Investments in mutual funds and other risky assets are subject to market risks. Please seek advice from an investment professional before investing.