Long-Short Equity Strategy
Also written Long-short strategy · 130/30 strategy
A Category III AIF strategy that buys stocks the manager thinks are under-priced and shorts those it thinks are over-priced — often run as a 130/30 fund with 100% net market exposure.
In plain language
A long-only manager who thinks a stock is over-priced can only avoid it. A long-short manager can bet against it.
The workbook says the Long-Short Equity Strategy aims to deliver absolute returns. It does this "by identifying over-priced and under-priced stocks, relative to the investment manager's fair valuation". The manager works out fair value through fundamental analysis. That analysis looks at the economy (macro-economic factors), the industry and government reforms.
The manager then takes a long ('Buy') position in under-priced stocks. It takes a short ('Sell') position in over-priced stocks. Unlike a long-only manager, it can do both even at the time of making the investment.
Say the long and short positions are in stocks that are alike, or in the same industry. Then the short side can act as a natural hedge against overall market risk.
How it works
130/30 funds. The workbook says these funds are also characterised as "130/30" funds (or 120/20, as applicable): the manager takes 130% long positions and 30% short positions, as a percentage of total investable funds, so that net exposure to the market is 100% of investable funds. The short positions are usually taken through options and futures on the underlying assets.
Net exposure can go either way. In a long-short strategy the manager may maintain a net long or a net short exposure; in a typical 130/30 fund, a net long position up to 100% of investable funds.
Leverage limit. Excessive leverage and short positions can increase volatility, so SEBI restricts leverage. Chapter 7 puts it as total exposure in long and short positions, net of offsetting positions, of not more than 2 times the fund's AUM. Chapter 5's prudential norms express the same limit as 2 times NAV:
Leverage = total exposure (long positions + short positions, after offsetting as permitted) ÷ NAV
The workbook's Example 2 (Fund TCR). Buys in Company B and D (large-cap), a sell in Company C, NIFTY50 put options as a hedge — and one buy and one sell in mid-caps. The workbook's point: the mid-cap positions do not perfectly offset each other, so the extra mid-cap exposure can significantly increase total risk and volatility.
Versus market-neutral. Long-short funds use long and short positions to take advantage of under- and over-valued opportunities; market-neutral funds use them to minimise systematic risk, aiming for a beta near zero.
A worked example
Illustrative figures. Kaveri 130/30 Fund, a Category III AIF, has investable funds and NAV of Rs 200 crore, and no offsetting positions.
Standard 130/30 book:
Long positions : 130% x 200 = Rs 260 crore
Short positions : 30% x 200 = Rs 60 crore
Net exposure : 260 - 60 = Rs 200 crore (100% of investable funds)
Total exposure : 260 + 60 = Rs 320 crore
Leverage : 320 / 200 = 1.6 times NAV -> within the 2x limit
The manager gets bolder — a 170/70 book:
Long positions : Rs 340 crore
Short positions : Rs 140 crore
Net exposure : Rs 200 crore (still 100%)
Total exposure : Rs 480 crore
Leverage : 480 / 200 = 2.4 times NAV -> breach
Net exposure has not changed at all, but total exposure — which is what the leverage limit measures — has jumped. Under the workbook's breach procedure, the fund must report the breach to the custodian, inform all investors before 10:00 AM on the next working day, and square off the excess exposure by the end of that day, confirming to investors; the custodian reports to SEBI.
Getting back within 2x needs total exposure of Rs 400 crore at most — for instance a 150/50 book (Rs 300 crore long, Rs 100 crore short).
Why NISM asks about it
Chapter 7 (Category III AIF Investment Strategies and Due Diligence Process) sets out the long-short equity strategy at 7.1.2 with the Fund TCR example, contrasts it with market-neutral at 7.1.3 and with short-bias and dedicated-long strategies at 7.1.4. Chapter 5 gives the leverage limit and breach procedure at 5.14.3. A Chapter 7 sample question turns on the difference between long-short and market-neutral. Expect questions on 130/30 arithmetic, net versus total exposure, and the 2x leverage limit.
Common exam traps
- 130/30 means 130% long and 30% short of investable funds, net 100% — not 130% net exposure.
- The leverage limit is on total exposure (long plus short, after permitted offsetting), not on net exposure. A 170/70 book has the same net exposure as a 130/30 book but far more leverage.
- The workbook states the base of the limit two ways: "2 times the Assets under Management" in Chapter 7 and "2 times of the net asset value (NAV)" in Chapter 5, where the ratio is defined with NAV as the denominator. Use NAV for computations.
- Long-short aims to exploit mispricing; market-neutral aims to neutralise beta. The sample question tests exactly this; net-zero sector exposure describes market-neutral, not long-short.
- A long-short manager may run net long or net short; a short-bias manager always runs net short.
- Long-short strategies can still be volatile and risky in economic downturns, especially with excessive leverage.
Check yourself
1.According to the workbook, how does SEBI restrict the leverage taken by Category III AIFs following a Long-Short Equity Strategy?
- a)Total exposure in long and short positions, net of any offsetting positions, cannot exceed 2 times the fund's Assets under Management
- b)Short positions cannot exceed 30 per cent of total investable funds, as in a 130/30 fund
- c)Net market exposure must always be exactly 100 per cent of total investable funds
- d)Short positions in any single company cannot exceed 10 per cent of investable funds
Show the answer
Answer: (a) Total exposure in long and short positions, net of any offsetting positions, cannot exceed 2 times the fund's Assets under Management
The workbook says excessive leverage and short positions can increase volatility, ‘Hence, SEBI restricts the leverage taken by Long-Short Funds, such that total exposure in long positions and short positions, net off any offsetting positions, is not more than 2 times the Assets under Management of the fund’.
- 130/30 (or 120/20) describes how many long-short funds are built. It is not a SEBI limit.
- A 130/30 fund results in net exposure of 100% of investable funds. The workbook does not make that a legal requirement.
- The 10% figure is the concentration limit on investment in a single investee company. It is not a leverage rule for short positions.
Where this is taught
Free preparation for NISM Series XIX-BRelated terms
- Category III AIFThe AIF category for funds running diverse or complex trading strategies with leverage — hedge funds and their kin — and the only category denied tax pass-through status.
- LeverageControl of a large contract value for a small upfront outlay — premium for an option buyer, margin for a futures position — which multiplies percentage gains and percentage losses by the same factor.
- Hedge FundA pooled vehicle using diverse or complex trading strategies, long and short positions and fund-level leverage — in India, the AIF Regulations place hedge funds in Category III.
- Directional StrategyA Category III AIF strategy that takes a net long or net short position on stocks or an index, betting on the market's direction; short-bias and dedicated-long are its variants.
- Global-Macro StrategyA Category III AIF strategy taking long and short positions across currencies, fixed income, equities, commodities, real assets and interest rate derivatives, driven by macro-economic trends.
- Market-Neutral StrategyA Category III AIF strategy taking equal long and short exposures within a sector, industry or market-cap segment so that portfolio beta is zero or close to zero.
- Short-bias StrategyA directional strategy in which the manager holds both long and short positions but keeps a net short exposure to the broad market, so the fund benefits when the market falls.
- Long-only Equity StrategyA Category III AIF strategy that takes only buy positions in selected stocks when investing, aiming at absolute returns over the medium to long term with a strong emphasis on capital preservation.
- Multi-Strategy FundA hedge fund, more common in European markets, that deploys several investment strategies within a single fund scheme rather than running one strategy alone.
- Convertible ArbitrageA Category III long-short strategy: buy a company's convertible bond or preference share and short its equity, to profit when the conversion terms and the share price fall out of line.