Hybrid Long Short For Uncertain Markets

Hybrid long-short: A sophisticated combination of equities, bonds and derivatives

In the past 16 months from September 2024, equity markets have been on an extended volatile run. The Nifty 50 is down about 5 per cent and the broader market Nifty 500 is 7.5 per cent lower over this time frame, with short periods of rallies followed by months of declines.

Factors such as penal US trade tariffs, geopolitical escalations, uncertainty over Central Bank actions, AI-led job disruptions, weakening Indian currency and FPI outflows have all played a part in keeping markets on tenterhooks, making them less predictable. Domestic earnings have been mixed, though macroeconomic indicators such as GDP growth, inflation and interest rates have remained positive for India in the last 3-4 quarters.

For investors, deployment of funds should always follow a well-defined asset allocation pattern so that volatility is countered smartly and healthy risk-adjusted performance is delivered by the portfolio over the long term. A hybrid framework would work best by combining equities, fixed income instruments and also derivatives (for risk management) – using a long-short strategy – to earn steady returns with relatively low volatility.

Specialized investment funds (SIFs), which are given considerable flexibility in deploying various strategies by market regulator SEBI, and come with minimum ticket size of Rs 10 lakh seem ideal vehicles.

Making long-short work

In the 18 years since the global financial crisis of 2008, the Nifty 50 TRI has given negative returns in three calendar years. In the long term, equities do tend to deliver healthy returns, though they can be volatile in the short and medium terms.

Bonds (CRISIL Composite Bond Index) has not given negative returns in the above timeframe and has delivered a steady performance.

Combining equity and debt, and including limited short exposure to equity and debt through derivatives forms the crux of a smart hybrid long-short strategy.

Now, for this strategy to be successful, a systematic process has to be followed. Stock and sector selection have to done actively based on market outlook, relative valuations and fundamental convictions. This process would involve taking into account metrics such as price to book (or price to earnings) for judging absolute and relative valuations, currency movements (real effective exchange rate), earnings yield versus bond yields, as well as momentum indicators such as the relative strength index (RSI).

Further, stock and sector positioning would need to be positioned based on market trend and FII moves (inflows, outflows). Next, derivative strategies need to be sharp. Arbitrage strategy (cash-futures, for example) for hedging is one such, which involves buying an asset at a lower price in one market and simultaneously selling it at a higher price in another market. Another hedging strategy involves covered calls. Here, a party sells or writes a call option, but has an equal amount of underlying assets. Buying stock puts is a directional derivatives strategy that allows an investor to benefit from a fall in a stock’s price, with the right, and not the obligation, to sell at a fixed strike price before the expiry date.

Fixed income strategies would involve buying carry-oriented debt instruments such as certificates of deposits, corporate bonds and commercial papers to earn reasonably better coupons. Finally, there must also be flexibility to participate in IPOs, QIPs, buy backs, block deals and other permitted avenues.

Disclaimer: Ravi Kalariya is the Founder & Managing Partner at I Plus Financial Services LLP. The views expressed are his own. This article is not part of Outlook Money’s editorial content, and Outlook Money does not endorse any views, products, or services mentioned.

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Disclaimer: The Views are Personal and not a part of the Outlook Money Editorial Feature