Global Liquid Alternatives vs Indian ‘Investment Strategies’
Liquid alternatives are reshaping the investment landscape, offering a bridge between traditional investment vehicles and sophisticated strategies typically reserved for institutional investors. These products, such as mutual funds and exchange-traded funds (ETFs), employ advanced investment techniques akin to those found in alternative investment funds in India. However, they stand out due to their liquidity, accessibility, and regulatory oversight, making them an attractive option for a broader range of investors.
Understanding Liquid Alternatives
Liquid alternatives provide investors with access to a variety of sophisticated strategies that can enhance portfolio performance and risk management. Some of the most notable strategies include:
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Long-Short Equity: This involves buying stocks expected to rise while short-selling those anticipated to fall, allowing investors to profit from both upward and downward market movements.
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Managed Futures: This strategy invests in futures contracts across various asset classes, including commodities and currencies, providing exposure to diverse market segments.
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Market-Neutral: By maintaining balanced positions, this approach aims to minimize market risk, making it an appealing option during volatile market conditions.
- Event-Driven: This strategy focuses on investing based on specific events, such as mergers and acquisitions, capitalizing on price movements that arise from these occurrences.
In contrast, Indian ‘investment strategies’ aim to diversify beyond the conventional buy-and-hold model that characterizes traditional mutual funds. With a minimum investment threshold of ₹10 lakh, these strategies target seasoned investors, offering greater flexibility and higher risk-taking capabilities while implementing safeguards such as no leverage and restrictions on unlisted and unrated instruments.
Performance of Liquid Alternatives Worldwide
The global landscape for liquid alternatives has evolved significantly, particularly following the 2008 financial crisis. Initially, these products were celebrated for democratizing hedge fund strategies, making them accessible to retail investors. They emerged as effective risk-management tools, providing diversification when traditional markets faltered.
However, the performance of liquid alternatives has been mixed. During the bull market of the 2010s, these products underperformed, delivering an average annualized return of just 1.66%, according to Morningstar. This underperformance can be attributed to regulatory restrictions under the US Investment Company Act of 1940, which limited leverage and short-selling capabilities, hindering these funds from fully replicating traditional hedge fund strategies.
Despite these challenges, liquid alternatives regained traction during the market volatility of 2021 and 2022, as investors sought ways to manage downside risk. These products provided returns that were uncorrelated with traditional benchmarks, showcasing their potential as a hedge against market downturns. However, the landscape shifted again in 2023, with bond price fluctuations and macroeconomic changes leading to another downturn.
In Canada, the growth of liquid alternatives has been notable, particularly following regulatory reforms in 2019 that expanded hedge-fund-like strategies within mutual fund structures. By March 2023, the Canadian liquid alternatives market reached C$26.4 billion. A key factor in this success was the greater leverage flexibility allowed by Canadian regulators, permitting leverage of up to 300% of net asset value, in stark contrast to the US cap of 33%. This flexibility attracted a broader investor base and enabled Canadian liquid alternatives to outperform their US counterparts during periods of market stress.
Key Learnings from International Experience
India stands to gain valuable insights from the experiences of the US and Canadian markets regarding liquid alternatives.
Investor Education: One of the most critical lessons is the importance of investor education. In the US, liquid alternatives were often marketed as replacements for hedge funds, leading to misaligned expectations among investors. It is essential for regulators and intermediaries in India to communicate that while these products can provide protection during volatile markets, they may underperform in bullish conditions.
Regulatory Constraints: The limitations faced by US liquid alternatives in replicating hedge fund strategies due to regulatory constraints on liquidity and leverage offer another important lesson. In India, the Securities and Exchange Board of India (SEBI) has imposed derivative exposure limits that, while prudent, could potentially reduce returns for certain strategies. Striking a balance between risk management and the opportunity for upside performance will be crucial for the success of India’s investment strategies.
Sophisticated Investor Base: Lastly, India’s growing base of sophisticated investors can benefit from volatility-reducing strategies such as market-neutral and managed futures. These strategies offer protection against market turbulence, providing diversification and minimizing exposure to broader market swings. The effectiveness of these strategies in managing risk and preserving capital during uncertain times, such as in 2022, highlights their potential as essential tools for safeguarding portfolios against unpredictable market conditions.
As India embraces these innovative investment strategies, the potential for liquid alternatives to enhance the depth and variety of the investment landscape is significant. By learning from global experiences, India can cultivate a robust framework for liquid alternatives that meets the needs of its diverse investor base.
Simarjeet Singh is an assistant professor at the Great Lakes Institute of Management, Gurgaon. Pradiptarathi Panda is an assistant professor at the Indian Institute of Management-Raipur. Rasmeet Kohli is senior assistant general manager at the National Institute of Securities Markets.