Category III AIF Investment Strategies and Due Diligence Process

1Directional equity strategies

• Long-only: buys stocks the manager expects to do well. Returns follow the market closely (beta near 1), plus or minus stock-selection alpha. Unlike a mutual fund, it may be more concentrated and use limited leverage.
• Long/short equity: buys stocks expected to outperform (long) and sells short stocks expected to underperform (short). Net exposure = longs − shorts; gross exposure = longs + shorts. A fund with 120% long and 50% short has net exposure 70% and gross exposure 170%.
• Short-bias: keeps more short than long (net exposure below zero). It aims to profit when markets or particular stocks fall, and is often used as a hedge in a wider portfolio.

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2Market-neutral and arbitrage strategies

• Equity market-neutral: balances longs and shorts so that net beta is near zero. Returns come from the spread between the stocks bought and sold (alpha), not from market direction.
• Cash-futures arbitrage: buys shares in the cash market and sells the same shares in futures when the futures price is above fair value, locking in the spread until expiry. Returns are low-risk and close to money market rates.
• Convertible arbitrage: buys a convertible bond and sells short the issuer's shares, to profit from mispricing of the conversion option while hedging equity risk.

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3Global macro

A global macro fund takes positions across countries and asset classes (equities, bonds, currencies, commodities) based on views of the economy, interest rates, inflation and policy. It is flexible and can go long or short, often with derivatives and leverage. Returns can be large but depend heavily on the manager's macro judgement.

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4Event-driven strategies

Event-driven funds profit from corporate events:

• Merger arbitrage (risk arbitrage): after a takeover is announced, the target's shares usually trade below the offer price because the deal might fail. The fund buys the target (and, in a share-swap deal, shorts the acquirer) to earn the spread if the deal completes. The main risk is deal failure.
• Activist investing: buys a meaningful stake and pushes management for changes, such as better governance, capital allocation, a sale or a spin-off.
• Special situations: demergers, buybacks, open offers, restructurings and index inclusions.
• Pre-IPO investing: buys shares of companies shortly before they list, aiming to gain from the listing. Risks include delayed or cancelled IPOs, lock-ins after listing and valuation risk.

Example A company offers ₹500 per share for a target trading at ₹470. A merger-arbitrage fund buys at ₹470. If the deal completes, it earns ₹30 (about 6.4%). If the deal fails, the price may fall back to ₹400.

Remember

• Long/short: net = long − short; gross = long + short.
• Market-neutral: beta ≈ 0. Short-bias: net short.
• Merger arbitrage: main risk is deal failure.

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5Due diligence

Before recommending a Category III fund, distributors and investors should assess:

• Strategy: is it clear, repeatable and suited to the market? Does the fund stick to it (no "style drift")?
• Team: experience, track record, stability, key-person risk, and the manager's own money in the fund.
• Performance: returns over full market cycles, risk-adjusted measures, drawdowns, and comparison with suitable benchmarks.
• Risk management: limits on leverage, concentration, liquidity and losses; who monitors them independently.
• Operations: independent custodian, fund accountant, valuer and auditor; controls over trading and cash.
• Terms: fees, hurdle, high-water mark, lock-ins, notice periods, exit loads and redemption limits.
• Compliance: SEBI registration, past regulatory actions, conflicts of interest and how they are managed.

Operational due diligence looks at the fund's processes and controls, not its strategy. Many fund failures come from operational problems, not bad investment ideas.

Remember

• Due diligence: strategy, team, performance, risk, operations, terms, compliance.
• Operational due diligence checks processes and controls.

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