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As 2021 comes to an end, it suddenly dawned on me that despite pandemic led fears globally, and India itself seeing a terrible second wave in May-June 2021, it has turned out to be a strong and relatively smooth year for equity markets (~+25 per cent) — an environment not seen since 2017. The fact that it came after 2020 which saw one of the fastest and deepest declines in the equities market followed by an equally fast and steep rise, and finally, closing the year up 15 per cent, is in itself remarkable, especially in the backdrop of Covid-related fears and news that keeps pouring in. So, 2021 wraps up the best two-year period for Indian equity markets since the 2012-2014 period, something I am not sure most of us have noticed given the overdose of distraction from news around Covid, politics, tech disruption and geopolitical issues, among others.
The key logical query that arises from this observation is, what next? After a few years of super-normal debt market returns (2015-2018), and now one of the best two-year period in a long time for equity markets (2020-2021), it's time to understand what lies in store for us and how can one get attractive risk-adjusted returns while handling the market conditions in the best possible way which in high probability will not be easy.
The reasons for it not being an easy investing environment in 2022 are as follows:
- Indian equity markets are trading at high multiples on an absolute basis, while being at one of the most extended relative multiples when compared with Asia ex-Japan and emerging markets. Due to this reason, most global banks downgraded Indian equities, recently.
- Earnings growth recovery and sustainability, while having shown early encouraging signs, are still not smooth and devoid of volatility. One wonders if the trend of reality hugely underperforming expectations on the earnings front, that has been seen over the past many years in India, will finally be broken.
- At the same time, certain long-term cycles from quant and technical side for both equity indices as well as demographics point to a secular bull market currently underway, and one of the best periods for Indian equity markets potentially ahead of us over the next few years. The capex cycle finally seems to be turning around, which also adds further comfort on this view.
So, this means there are high chances of a tug-of-war between bulls and bears and sector rotation as well as high stock dispersion with some performing strongly while others performing poorly, and most things not being highly correlated in terms of performance or stock moves. Hence, the best way one can take advantage of such a market environment might not be from a directional strategy, such as long equities, but market-neutral and long-short strategies, as these strategies will be able to take advantage of the high intra-sector and inter-sector dispersion of returns, especially when correlation across stocks and sectors is low (interestingly, across the globe and not just in India).
What are equity market-neutral strategies?
These strategies attempt to exploit relative performances in stock prices by being long and short with an equal amount in various stocks.
We explain this using a scenario. Based on a ranking from a quant perspective, let’s select five stocks from the BSE 100 that we think will rise and five stocks that we think might not do well over a certain period. Then assume we have INR 100 as assets under management (AUM), a market-neutral approach would require us to split this amount among the five stocks on each of the long and short side via stock futures (so we would buy Rs 20 worth of each of the 5 stocks we want to go long and we would sell Rs 20 worth of each of the 5 stocks that we want to go short). Now, this is possible in an AIF fund as the Securities and Exchange Board of India (SEBI) allows 200 per cent gross exposures of the AUM in the futures market (so Rs 100 long exposure and Rs 100 short exposure would mean gross exposure of Rs 200 and net exposure of zero). Given the approach, the net exposure to the equity markets comes to zero, as we are equal on both the long and short side — i.e., +100 and -100. This strategy has low market risk as it has zero net exposure, while playing the relative performance between the bunch of stocks that one has gone long and the stocks on which one has gone short.
As the net exposures to the underlying equity market is zero, it won't matter much what the actual equity market does. This market-neutral strategy eliminates large tail risk and is not correlated to equity or debt markets.
The objective behind such strategies is to generate absolute returns rather than directional returns. It attempts to offer consistent annual returns with relatively low risk as it eliminates systematic risk by having zero net exposures to the market, and takes advantage of high volatility or high dispersion in the market, across stocks and sectors.
Hence, such strategies can truly be an all-weather friend and could be the most interesting for the year ahead.
Modified version of the article that first appeared on economictimes.indiatimes.com.