Sebi’s ‘investment Strategies’: India’s answer to liquid alternatives

Global liquid alternatives vs Indian ‘investment strategies’

Liquid alternatives are investment products such as mutual funds and exchange-traded funds that use strategies similar to alternative investment funds in India. However, these are more liquid, easier to access, and regulated. 

These products enable investors to access sophisticated and advanced investment strategies such as long-short equity (buying stocks whose prices are expected to increase and selling those that are expected to fall); managed futures (investing in futures contracts across asset class—commodities, currencies, etc.); market-neutral (maintaining balanced positions to minimize market risk); and event-driven approaches (investing based on events such as mergers and acquisitions). These strategies are typically available only to institutional investors and high net worth individuals.

Indian ‘investment strategies’ will enable investors to diversify beyond the traditional buy-and-hold model that defines conventional mutual funds.

This asset class offers greater flexibility and higher risk-taking capabilities for large investments while implementing safeguards such as no leverage (i.e., not borrowing funds to enhance investment exposure), which reduces risk, restricts investments in unlisted and unrated instruments, and includes a 25% limit on derivatives exposure for purposes other than hedging and rebalancing.

With a minimum investment of ₹10 lakh, it targets seasoned investors and aims to enhance the depth and variety of India’s investment landscape.

Performance of liquid alternatives worldwide

Globally, liquid alternatives gained momentum following the 2008 financial crisis, particularly in the US. Initially, these were lauded for “democratizing” hedge fund strategies by making them accessible to retail, or individual, investors. Liquid alternatives proved effective as a risk-management tool, providing diversification when traditional markets falter. 

However, the performance has been mixed, offering important lessons for India.

During the bull market of the 2010s, liquid alternatives significantly underperformed, delivering an average annualized return of just 1.66%, according to Morningstar. This category lagged other mutual fund categories. Restrictions under the US Investment Company Act of 1940, such as a 33% leverage cap and limits on short-selling, hindered these funds from replicating traditional hedge fund strategies. 

Despite this, liquid alternatives regained popularity during the market volatility of 2021 and 2022 as investors sought alternatives to manage downside risk. Liquid alternatives provided returns uncorrelated with traditional benchmarks. However, the markets experienced a downturn in 2023 due to bond price fluctuations and shifts in macroeconomic trends.

In Canada, liquid alternatives grew significantly after the 2019 regulatory reforms that expanded hedge-fund like strategies under mutual fund structures, reaching C$26.4 billion by March 2023.

A key to Canada’s success in liquid alternatives was greater leverage flexibility. Canadian regulators allowed leverage of up to 300% of the net asset value, while the US had a cap of 33%. This attracted a broader investor base and helped Canadian liquid alternatives outperform their US counterparts during market stress.

Key learnings from international experience

India can draw valuable lessons from the US and Canadian experience with liquid alternatives. First, investor education is crucial. In the US, liquid alternatives were promoted as hedge fund replacements, leading to misaligned investor expectations. Regulators and intermediaries must ensure that while these products protect volatile markets, they may underperform in bullish conditions.

Second, US liquid alternatives faced limitations in fully replicating hedge fund strategies, primarily due to regulatory constraints on liquidity and leverage. Sebi’s derivative exposure limits exposure, which, while prudent, could reduce returns for some strategies. Balancing risk management with opportunities for upside performance is key to the success of India’s ‘investment strategies’.

Lastly, India’s growing base of sophisticated investors can benefit from volatility-reducing strategies, like market-neutral and managed futures. These strategies protect protection against market turbulence, offering diversification and minimizing exposure to broader market swings. During uncertain times, such as in 2022, these strategies proved effective in managing risk and preserving capital. As India embraces these innovations, such products could become an essential tool for safeguarding portfolios against unpredictable market conditions.

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 National Institute of Securities Markets.