SIFs are designed to improve risk-adjusted returns: Edelweiss' Bhavesh Jain

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Specialized Investment Funds (SIFs) are positioned between mutual funds (MFs) and high-ticket investment products such as portfolio management services (PMS) and alternative investment funds (AIFs). In an interview with Mint, Bhavesh Jain, president and co-head, factor investing, Edelweiss Mutual Fund, explains how SIFs differ, where they fit in an investor's portfolio and what investors should expect in terms of returns, risk and liquidity.

SIF is becoming a very interesting public investment vehicle. If you look at the options available today, a retail investor can start with a mutual fund with small amounts. But if he wants to upgrade, the next available options are PMS and AIF, with minimum ticket sizes of ₹50 lakh and ₹1 crore, respectively.

Now, an investor with an investable corpus of ₹10-50 lakh cannot invest the entire amount in a PMS because the minimum investment is ₹50 lakh. That is the first gap that SIF bridges.

The second gap is flexibility. MFs are tightly regulated. In a large-cap fund, 80% has to be invested in the top 100 stocks. In a mid-cap fund, 65% has to be invested in the designated mid-cap universe. Even if we are negative on a particular stock, sector or even the broader market, at best we can take a hedge trade or a cash call. We cannot go short and earn profits when our negative view is right.

SIF changes that. It allows us to take short positions, although only up to about 20-25% of the AUM. Moving from zero to 25% is a meaningful increase in flexibility.

Another important difference is that there is no requirement to maintain fixed allocations across large-cap, mid-cap and small-cap stocks. The allocation depends on the product being managed.

Like MFs, SIFs will have multiple categories. Some products will compete with balanced advantage funds and equity savings funds, while others will compete with flexi-cap, mid-cap or small-cap funds. But the biggest advantage SIF has over a traditional MF is the freedom to use derivatives. That not only means short selling, but also using covered calls, straddles, strangles and other options strategies, many of which are not directional bets but are designed to generate regular income or exploit arbitrage opportunities.

Just because we have greater freedom to use derivatives does not mean risk automatically goes up. In fact, if you look at today's most conservative equity product, the arbitrage fund, it is almost entirely based on derivatives. Balanced advantage funds and equity savings funds also use derivatives extensively to manage volatility.

If markets fall 10%, a normal equity fund will broadly decline by around 9-11%, depending on the alpha generated. But in an SIF, if derivatives are used properly in the form of hedging or selective short exposure, volatility should be lower than in a traditional long-only MF. So SIFs should actually be better positioned to manage downside volatility.

It is also important to understand that the Securities and Exchange Board of India (Sebi) has not allowed leverage in SIFs. Leverage is the biggest source of risk. So investors should not assume that simply because derivatives are allowed, SIFs are necessarily high-risk, high-return products. If used correctly, derivatives can actually reduce risk.

The primary objective of any long-short strategy is to give investors a smoother experience over the long term. Instead of focusing only on headline returns, investors should start looking at risk-adjusted returns.

Take the example of the same fund manager running both a traditional MF and an SIF strategy with the same underlying portfolio. Because the SIF manager can take derivative positions, write covered calls and take selective short positions, he has additional tools to generate alpha. The underlying portfolio could be identical, but because of the extra flexibility available in an SIF, the manager should be in a position ...