Part II Why Long short funds / strategies? In the previous article I went through the basics of a long short strategy. Investors may wonder, and question, why should one invest in a strategy like this one? It’s a very valid and interesting question to which the answer is even more interesting. Let me explain. Kindly bear with me for being a bit technical. In any investment an investor takes certain amount of risk for generating return expected by him. The two very important aspects for an investor while evaluating any strategy are “Risk” and the “Returns” expectations. Irony is that large part of the investor community wants least amount of risk with maximum returns, which is an illusion. It is extremely important to see and understand that investors risk apetite marries with the risk profile of the investment strategy. If that’s not understood one may have ugly experiences as what has happened in the past. Let us take each of the aspect separately and begin with assessment of risk. Risk can be measured by various ratios viz-­‐Standard deviation (volatility), sharpe ratios, sortino ratios etc. Volatility generally denotes the risk of movement of returns of the underlying strategy or instrument. For instance general band of nifty volatility is around 16 and any subsequent long only equity fund (Mutual fund or PMS or Insurance) is closer to 20, at the same time any debt fund volatility would tend to be between 2 – 5. Higher the volatility, higher is the perceived risk. The commensurate return expectation is generally directly proportional to the risk one takes. So in the above case the return expectations in a debt fund, where volatility is between 2 – 5, is far lower than an equity fund, where the volatility is around 20. So one has to assess the fund characteristics with the volatility measure. The patience and resilience of an investor gets tested in tough times. Even though one might be aware of risks, when actually markets crash, most investors get perturbed with the mark to market losses on the books. This is the time when leaving fundamentals aside the behavioral aspect of investors play a dominant role in their investment decisions, like what happened in 2008. In the Exhibit, if an investor would have invested in equities from 2001 and would have stayed till date they would have earned about 14 – 15% compounded return. At the same time they would have earned this return while experiencing the 3 big drawdown periods as marked in the chart. To extend further, we saw maximum inflows in the year of 2007, which was the peak of the market. What does this imply? It simply says that it is very difficult, one, for an investor to be so long term and stay invested for 13 years from point to point and two, that behavioural aspect of investors generally makes them invest maximum close to peaks. What this does is that one loses confidence of investing in an asset class, in this case, equities. At the same time, because of the bad experience of huge drawdowns, it makes it extremely difficult to invest later at much lower levels after huge correction in the indices. So how can one overcome these big drawdowns while earning consistent returns of about 15 – 20% consistently over a longer period of time irrespective of market volatility? The answer to this question brings me to a concept called “Risk Adjusted Returns”. How about reducing the volatility in equity as an asset class while earning consistent returns. It is with this precise objective that the long/short combination strategy operates. The long short combination strategy ideally smoothens out the returns and tries to aim the same objective of long term equity fund over a longer period of time. To summarize, an equity long short combination fund / strategy decreases volatility compared to benchmark indices in earning returns and tries to achieve consistent returns without having to worry big drawdowns. It is also in harmony with the behavioral aspect of investment decisions. It enables an investor to being exposed to equity as an asset class without a need to worry of major capital erosion over longer period of time. In the last part of this series of articles I will try highlighting the importance of shorts on one hand and also the importance of long short strategies in overall asset allocation.