Category III AIF Investment Strategies | Equity and Global-Macro

Category III AIF Investment Strategies refer to the diverse methods adopted by Category III Alternative Investment Funds (AIFs) to generate absolute returns by investing in equities, derivatives, currencies, and other asset classes. These strategies include long-only, long-short, market-neutral, directional, short-bias, and global macro approaches, each designed to balance risk and reward based on market conditions. Category III AIFs often employ leverage, hedging techniques, and derivatives to enhance portfolio performance while managing volatility. These strategies are defined and disclosed in the fund’s Private Placement Memorandum (PPM) to ensure transparency and investor awareness.

Table of Contents

1. Equity-Market Investment Strategies
2. Global-Macro Strategy

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1. Equity-Market Investment Strategies

Category III AIFs have been primarily investing in Equities and Derivatives contracts, with Equities or Equity Indices as the underlying asset.

A Category III AIF is a pooled investment vehicle, which collects investment capital from investors to invest the funds over a long-term. Category III AIFs may take leverage, short positions and derivative positions, in order to generate absolute returns for investors over the medium and long term. Hence, these funds generally do not invest for the purpose of intra-day trading. Speculative investments in equities may be made, if the investment manager can predict short-term profit generation for the fund. The targeted sector for investment, basis for selection of investments, time horizon and risk-return profile of selected investments are clearly outlined by the investment manager, in the Investment Strategy of the Category III AIF. The Investment Strategy is also disclosed to the investors, in the Private Placement Memorandum (PPM) of the fund. By making capital commitments to the fund, the investor indirectly provides consent to the investment manager on the stated investment strategy.

Equity-Market Investment Strategy followed by Category III AIFs is a diverse and complex strategy formulated by the Investment manager, stating the nature of positions to be taken in Equities or Derivatives contracts. The Investment Strategy may be to invest by taking only long positions in Equities, or short positions in Equities, or a combination of both types of positions. Common types of Equity-Market Investment Strategies are explained below:

1.1 Long-only Equity Strategy

The Long-only Equity Strategy focuses on delivering absolute returns for investors over the medium to long-term, with a strong emphasis on capital preservation. In a Long-only Strategy, the Category III AIF manager would take long positions, or ‘buy’ positions in the selected stocks. Investment managers make stock selection using a top-down or bottom-up fundamental approach, with an aim to invest in companies having predictable, scalable and quality business models. In order to invest in such companies, the investment manager would analyse historical data of the target companies of dividend pay-outs, return on capital employed and other important financial parameters.

However, in order to protect the fund against losses, a prudent investment manager may take a “hedging position” to minimise the market risk due to decrease in value of a stock. Hedging positions can be taken by taking opposite positions, i.e. a Sell position, in a Futures or Options contract of the stock or index under consideration. A sell position can be taken through a “Short” position in a Futures contract or by buying a “Put” option, with the underlying asset having similar characteristics as the reference asset in the portfolio. Despite hedging positions taken by an investment manager, a Long-only Strategy may be volatile and risky, during economic downturns. Let us understand the Long-only Strategy, using the following example.

Example – Fund FGH is a Category III AIF, with a Long-only Investment Strategy. Investments are made in large-cap stocks and mid-cap stocks. Analyse the investments made by the fund

Long Positions – As on April 1, 2023

Particulars	Quantity	Market Price Per Share (INR)	Total Value (INR)
Stocks – Large-cap
Company A	1,00,000	320	3,20,00,000
Company B	10,00,000	50	5,00,00,000
Company C	3,00,000	250	7,50,00,000
Company D	4,00,000	500	20,00,00,000
Stocks: Mid-cap
Company E	1,00,000	500	5,00,00,000
Company F	1,00,000	930	9,30,00,000

Analysis – Fund FGH has taken Long Positions in Large-cap and Mid-cap stocks. Considering the unexpected volatility of the stock market, it is advisable that the investment manager takes a hedging position against any future downfall. Futures and Options in a broad-based market index such as NIFTY50 or S&P BSE SENSEX can partially hedge the inherent market risk of the Fund. Options can prove to be more efficient as compared to Futures, for hedging purpose. The most suitable hedging strategy can be to Buy a Put Option on the NIFTY50 or S&P BSE SENSEX, or a combination of the indices, and keep rolling the option contracts forward. One example of a hedging position is given below:

Hedging Positions

Particulars	Strike Price	Lot-size (Contracts)	Quantity (Lots)	Market Price (INR)	Total Exposure (INR)
Put Options Bought
NIFTY50 – Expiry – 31 Dec 23	9000.00	450	150	500.00	3,37,50,000

As seen from the table above, the Fund FGH can take Put options in NIFTY50, with an expiry of December 31, 2023, which is nine months from the date of holding securities. These contracts can be rolled forward to a future expiry date, based on the years for which the same investments will be held by the Fund FGH. The hedging positions, type of contracts and indices used should be changed on a regular basis, to replicate the characteristics of the investments in the fund portfolio.

1.2 Long-Short Equity Strategy

The Long-Short Equity Strategy focuses on delivering absolute returns, by identifying over-priced and under-priced stocks, relative to the investment manager’s fair valuation. Fair Valuation of target stocks is done using fundamental analysis and taking into account macro-economic factors, industry-specific factors and government reforms. As per the investment strategy, the investment manager will have the freedom to take a long position, or ‘Buy’ position, in under-priced stocks and a short position, or ‘Sell’ position, in over-priced stocks. These funds are also characterised as ‘130/30’ funds, (or 120/20, as applicable) which means, the investment manager takes 130 percent long positions and 30 percent short positions, as a percentage of the total investable funds. This ensures that the net exposure to the market is equal to 100 percent of the value of total investable funds. The short positions are usually undertaken by investing through the options and futures contracts on the underlying assets.

In contrast with a Long-only Strategy, the investment manager can take a short position in stocks, even at the time of investments in stocks. This provides greater flexibility to the investment manager and can create a natural hedge against total market risk of the Category III AIF. This is possible if both short positions and long positions are taken in stocks, which have the same characteristics or in the same industry. Long-short Strategy can be volatile and risky, during economic downturns. Excessive leverage and short positions taken by the investment manager can also increase the volatility of the fund. Hence, SEBI restricts the leverage taken by Long-Short Funds.

Let us understand the Long-short Strategy, using the following example.

Example – Fund TCR is a Category III AIF, with a Long-short Investment Strategy. Investments are made in large-cap and mid-cap stocks, as well as derivative contracts. Analyse the investments made by the fund.

Positions in Stocks and Derivatives – As on April 01, 2023

Particulars	Exposure	Quantity	Market Price (INR)	Total Value (INR)
Stocks – Large-cap
Company B	Buy	10,00,000	50	5,00,00,000
Company C	Sell	3,00,000	250	7,50,00,000
Company D	Buy	4,00,000	500	20,00,00,000
Stocks – Mid-cap
Company E	Buy	1,00,000	500	5,00,00,000
Company F	Sell	1,00,000	930	9,30,00,000

Particulars	Strike Price	Lot-size (Contracts)	Quantity (Lots)	Market Price (INR)	Total Exposure (INR)
Put Options Bought
NIFTY50 – Expiry – 31 Dec 2023	9000.00	450	50	500.00	1,12,50,000

 Analysis – As seen from the tables above, Fund TCR has taken both buy and sell positions in Large-cap stocks, and hedged the risk by buying adequate Put options in NIFTY50, with an expiry of December 31, 2023, which is nine months from the date of holding securities. However, the Fund has an additional exposure to Mid-cap stocks. The investment manager has taken a buy position in one stock and a sell position in another stock in the Mid-cap sector. However, such exposures are not perfectly offsetting the market risk and total exposure to the Mid-cap sector. Such exposure in the Mid-cap sector can significantly increase the total risk and volatility of the fund.

1.3 Market-Neutral Strategy

The Market-Neutral Strategy, like the Long-Short Strategy focuses on delivering absolute returns, by identifying over-priced and under-priced stocks, relative to the investment manager’s fair valuation. However, difference in Market-Neutral Strategy is that the Category III AIF has net ‘zero’ or ‘neutral’ exposure to a particular sector, industry or market-capitalisation of companies in the equity market. As per the investment strategy, Category III AIF managers take equal amount of long and short exposures in Equities, through long positions in under-priced stocks, and short positions in over-priced stocks. As the Category III AIF is neutral to the broad-based market index, industry or sector, the ‘Beta’ or systematic risk of the fund is zero, or close to zero. Investment Managers may use either fundamental analysis or quantitative algorithms, to estimate growth of a company’s stock, and take long or short positions, accordingly.

In contrast with Long-short Strategy, the investment manager of a Market Neutral Strategy will have to ensure that the Portfolio Beta is not significantly higher or lower than “Zero”. A high Beta signifies greater volatility of the fund. Hence, the investment manager has low flexibility to trade freely in various stocks, by market capitalisation, industry or sector. Market-Neutral funds use long and short positions with the aim of minimising the systematic risk of the portfolio, whereas, long-short funds use long and short positions with the aim of taking advantage of undervalued and overvalued opportunities.

A zero Beta does not ensure that the Strategy is not volatile or risky, during economic downturns. Excessive leverage and concentrated positions taken in stocks can also increase the volatility of the fund. Let us understand the Market-Neutral Strategy, using the following example.

Example – Fund PQC is a Category III AIF, with a Market-Neutral Investment Strategy. Investments are made in large-cap and mid-cap stocks, using derivative contracts or direct equity exposure. Analyse the investments made by the fund.

Positions in Stocks and Derivatives – As on April 01, 2023

Particulars	Exposure	Quantity	Stock Beta	Market Price (INR)	Total Value (INR)
Large-cap Stocks
Company B	Buy	10,00,000	0.40	50	5,00,00,000
Company C	Buy	2,00,000	2.00	250	5,00,00,000
Company D	Sell	2,00,000	1.20	500	(10,00,00,000)
Net Exposure					0.00
Mid-cap Stocks
Company E	Buy	1,00,000	1.50	500	5,00,00,000
Company F	Sell	1,00,000	1.50	500	(5,00,00,000)
Net Exposure					0.00

Particulars	Strike Price	Lot-size (Contracts)	Quantity (Lots)	Market Price (INR)
Index Options – Bought
NIFTY50 – Call Expiry – 31 Dec. 2023	10000.00	750	30	750.00
NIFTY50 – Put Expiry – 31 Dec. 2023	9500.00	450	50	500.00

Analysis

As seen from the tables above, the Fund PQC has taken Buy and Sell positions in Large-cap stocks as well Mid-cap stocks. The long and short exposures in both segments is neutral, as the total amount invested in Long positions in Large-cap stocks is equal to the total amount invested in Short positions in Large-cap stocks. Similarly, the total amount invested in Long positions in Mid-cap stocks is equal to the total amount invested in Short positions in Mid-cap stocks.

The portfolio beta is zero, as the total exposure to the broad-based market is neutral. The portfolio beta is computed as the total of weighted average of the stock-specific Beta, within each class of investments, computed as follows:

Particulars	Stock Beta [A]	Value of Investment	Weights* [B]	Weighted Average Beta [A*B]
Large-cap Stocks
Company B	0.40	5,00,00,000	0.25	0.10
Company C	2.00	5,00,00,000	0.25	0.50
Company D	1.20	(10,00,00,000)	0.50	(0.60)
Total		NIL		0.00
Mid-cap Stocks
Company E	1.50	5,00,00,000	0.50	0.75
Company F	1.50	(5,00,00,000)	0.50	(0.75)
Total		NIL		0.00

* Weights are computed by dividing the investment in the company, by the total investments in the sector-specific stocks, viz. large-cap stocks and mid-cap stocks respectively.

However, the exposures in individual stocks bear risk, unrelated to the market risk. This is also known as Unsystematic Risk. The individual price movements of each stock can significantly change the portfolio mix, as the investment manager will again need to bring the Portfolio Beta to Zero.

On analysing the positions in NIFTY50 options, it is observed that the fund has taken a Call Option on NIFTY50, with a Strike Price of 10,000 and a Put Option on NIFTY50, with a Strike Price of 9500. Expiry Dates for the Call option and Put option are same, i.e. December 31, 2023. Total exposure taken in terms of number of contracts is the same in Call Options and Put Options, i.e. 22,500 contracts. The Fund has neutralised the exposure to NIFTY50, for any value above 10,000 or any value below 9,500. However, the fund will be exposed to market risk, if the NIFTY50 value as on December 31, 2023 is between 9500 and 10000. Due to different strike prices of the NIFTY50 options, the portfolio beta is not zero. Hence, the positions taken in the derivatives contracts are NOT Market-Neutral, as observed in positions taken in Large-cap stocks and Mid-cap stocks. The Portfolio Beta, after taking into consideration all positions in equity markets and derivative markets, will be close to zero.

Practically, the portfolio beta will not remain exactly zero, for a Category III AIF following the Market-Neutral Strategy. For instance, in our example the portfolio beta was changed due the Index Options taken on NIFTY50. If these options are taken for the purpose of hedging market risk, then a change in Portfolio Beta is justified. Hence, Portfolio Beta of close to zero is also justified, if a Category III AIF is pursuing a Market-Neutral Strategy.

1.4 Directional and Short-Bias Strategies

A Directional Strategy focuses on delivering absolute returns for investors by taking either a net long position or a net short position in the selected stocks or a broad-based market index. The Category III AIF manager takes an investment call on the direction of the overall market, over the short-term or medium to long-term. If the investment manager has taken net long positions, the fund will benefit from an upward movement in the market, and vice-versa. A Directional Strategy is an opposite of a Market-Neutral Strategy, as the investment manager will not aim at having a Portfolio Beta of zero or close to zero.

Short-bias Strategy is a type of Directional Strategy, wherein the investment manager takes both long and short positions in selected stocks or a broad-based market index, but maintains a net short exposure to the broad market. A Short-bias Strategy will also benefit from downward movement in the market.

Short-bias Strategy differs from a Long-only Strategy, as the fund maintains a net long exposure in a Long-only Strategy and net short exposure in a Short-bias Strategy. Similarly, in a Long-short Strategy, the investment manager may maintain a net long or a net short exposure, as compared to the net short exposure to be maintained in a Short-bias Strategy. In a typical ‘130/30’ long-short strategy, the investment manager maintains a net long position, up to 100 percent of the total investable funds.

The Dedicated-Long Strategy also differs from the long-short strategy. The investment manager may take both long and short positions in the long-short strategy, as compared to exclusively taking long positions in a Dedicated-Long Strategy. A Directional Strategy and a Short-bias Strategy may be volatile and risky, during major macro-economic upturns as well as downturns, depending on the net exposure taken by the investment manager. Let us understand the Directional Strategy and Short-bias Strategy, using the following example.

Example – Fund LMN and Fund TGR are Category III AIFs. Investments are made in large-cap stocks, mid-cap stocks, using derivative contracts or direct equity exposure. Identify the Investment Strategy pursued by both funds and analyse the investments made by the funds.

Fund LMN

Positions in Stocks: As on April 1, 2023

Particulars	Exposure	Quantity	Market Price (INR)	Total Value (INR)
Large-cap Stocks
Company C	Buy	2,00,000	250	5,00,00,000
Company D	Sell	2,00,000	500	(10,00,00,000)
Net Exposure				(5,00,00,000)
Mid-cap Stocks
Company E	Buy	1,00,000	500	5,00,00,000
Company F	Sell	1,50,000	500	(7,50,00,000)
Net Exposure:				(2,50,00,000)

Fund TGR

Positions in Stocks – As on April 1, 2023

Particulars	Exposure	Quantity	Market Price (INR)	Total Value (INR)
Large-cap Stocks
Company H	Buy	5,00,000	700	35,00,00,000
Company I	Buy	2,00,000	1500	30,00,00,000
Net Exposure				65,00,00,000

 Equity Derivatives Exposures: As on April 01, 2023

Particulars	Strike Price	Lot-size (Contracts)	Quantity (Lots)	Market Price (INR)
Index Options – Bought
NIFTY50 – Call Expiry – 31 Dec. 2023	10000.00	750	30	750.00
NIFTY50: Call Expiry – 31 Dec. 2023	9500.00	750	50	805.00

Analysis

As seen from the tables above:

Fund LMN is pursuing a Short-bias Strategy. The fund has net short positions in Large-cap stocks as well as Mid-cap stocks.

Fund TGR is pursuing a Directional Strategy, particularly a Dedicated-Long Directional Strategy. The fund has bought shares of large-cap stocks as well as taken Call Options on the broad market index – NIFTY50, for a later expiry date, which indicates that the fund will profit if the NIFTY50 value increases.

2. Global-Macro Strategy

Unlike Equity Market Strategies discussed above, Category III AIFs pursuing a Global Macro Investment Strategy can take both long and short positions across asset classes such as currencies, fixed income securities, equities, commodities, real assets and interest rate derivatives. The objective of the fund will be to earn positive absolute returns for the investors, by investing in multiple markets and geographies. Global-Macro Strategies helps a fund to diversify across multiple asset classes and manage total risk of the fund portfolio.

The investment manager makes stock selection primarily based on macro-economic trends and factors, instead of fundamental analysis of historical data of every company. Major players in the Category III AIF market have advanced Algorithms to analyse macro-economic trends on multiple dimensions, utilising both quantitative and discretionary inputs.

The fund may apply a long-only strategy, market-neutral strategy, directional strategy or a long-short strategy to invest across multiple markets, asset classes and geographies. For example, a global macro investment manager may decide to take long positions in Indian corporate debt securities, short positions in Euro, long positions in U.S. T-bills and stay market-neutral when investing in Crude, subject to regulatory guidelines published from time to time. Let us understand the Global Macro Strategy, using the following example.

Example – Fund GMS is a Category III AIF, with the following holdings, as on April 30, 2023. Identify the Investment Strategy pursued by the fund and analyse the investments made by the fund.

Particulars	Exposure	Quantity	Market Price (INR)	Total Value (INR)
Large-cap Stocks
Company J	Buy	2,00,000	1,000	20,00,00,000
Company K	Buy	1,00,000	2,250	22,50,00,000
Mid-cap Stocks
Company E	Buy	10,000	500	50,00,000
Company F	Buy	10,000	500	50,00,000

Other Exposures – Currency

Particulars	Lot-size (Contracts)	Quantity (Lots)	Futures Price
Currency Futures – Short Positions
USDINR 20MAYFUT	1000	150	75.20
GBPINR 20MAYFUT	1000	150	94.10