Market Neutral Funds: Look Before You Jump

Avendus Capital recently launched a Class III Alternative Investment Fund (AIF) – the market-neutral Avendus Fund. Market neutral funds are funds that both buy and sell a stock, thus reducing or eliminating market risk.

There are already a number of private equity funds that partially hedge their portfolio but very few funds in India are seeking to phase them out completely. Such a strategy can outperform a “buy and hold” or “buy only” strategy in a downtrend market. Nifty stock has fallen by 11% since the beginning of 2022. However, experts suggest buying in these funds only after establishing a track record. Since these chests are AIFs, they have a minimum ticket size of R1 crore.

The Avendus Market Neutral Fund, which seeks to completely eliminate market risk, will be allowed to deviate only 10% from a 100% hedge position (long and short positions of equal size). It will do this using stock futures and will primarily target the 100 largest listed companies. Avendus Capital already owns one such offering – the Avendus Absolute Return Fund. However, the new scheme will use a quantum-based strategy and target after-tax and post-trial returns of 8-11%.

There are two types of risks in investing in stocks. 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 choosing the wrong stock. “Alternative Strategies for Public Markets,” said Vibhav Sanjavi, co-CEO of Avendus Capital. According to Sanghvi, such diversified strategies will reduce the risk of making wrong trades. It will be open with an exit burden of up to 6 months retention period. For an investment of 6 months. R1 crore to R5 crore, the fund will incur 1% management fee and 25% performance fee over a 10% hitch. For example, if a group of files R1 crore re R20 lakh, Avendus will charge a management fee of R1 lakh. You will also charge a performance fee on the yield generated by 10%. This come back to R9 lakh (after accounting for management fees) and therefore performance fees will be R2.25 lakh.

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In India, Class III AIFs – some of which are hedging a portion of their exposure – are moving away from being completely market neutral. One of the main reasons for this is the tax treatment of these funds. Class III AIFs must deduct a 42.7% tax at source on business income that is considered income from business and professions. This eats into after-tax revenue in a big way. This is why market-neutral funds have not yet made a significant appearance in India,” said Nalen Muniz, Chief Investment Officer at Alternative Equity, Edelweiss Asset Management Ltd.

The Avendus Market Neutral Fund targets an after-tax return of 8-11%. This translates to a pre-tax return of 19-26% if you are at the top of your tax bracket. For those in the 30% tax bracket, the after-tax return will be higher.

A market-neutral fund can outperform a traditional long stock fund only in a bear market or a relatively range-limited market. However, investors should take note of the taxes. The risk of stock selection, or the risk of a fund manager choosing the wrong stocks to buy and sell, also remains on the table. “For all algorithm-based and quantitative strategies, we typically look at actual portfolio data for at least one year and ideally two years. Tested returns have their own challenges,” said Monish Randiv, founder and CEO of Servin Family Office.

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