A combination of both might work. Otherwise, it’s time to lie low.
Hedge funds are considered instruments for the sophisticated. Hedge funds often take unacceptable risks. They trade everything including exotic over-the-counter (OTC) derivatives. They use huge leverage. Fee structures are rapacious. Most people are afraid of them.
But a hedge fund's mandate is very simple. Hedge funds shoot for absolute positive returns, regardless of market conditions. Unlike mutual funds, hedge funds are not benchmarked to index performance.
Any individual investor runs his own private hedge fund in terms of mandate because he too looks for a positive return, regardless of market conditions. While individuals cannot touch some institutional markets, and cannot access (or even understand) OTC, they can mix assets, or take short positions.
Short selling is forbidden for mutuals. They are also restricted to buying certain assets, due to their mandates. This makes it difficult to generate positive returns during bear markets. Very few funds beat their benchmarks in 2011. Of those, most had negative absolute returns.
The debt market has been bearish for the past 18 months. The RBI's rate hikes commenced in February 2010, and started hitting debt fund returns by May-June 2010. The stock market peaked in November 2010 and it has lost 25 per cent since then.
Investors using publicly-traded debt and equity instruments have been successful with very few strategies in 2011. One winner was a long USD position. Buying the USDINR futures offered handsome returns, given 50:1 leverage. Another successful strategy was short selling equity indices, and stock futures, using derivatives. Again, huge returns came with leverage at upwards of 10:1.
The third successful strategy was very selective buying of the few stocks that rose. Mutual funds could only use the third strategy. Between January 2011-December 2011 timeframe, approximately 85 per cent of listed stocks lost ground. If you consider the 200-odd stocks in the derivatives segment (this includes the Nifty and Junior), 88 per cent dropped in price, or traded flat.
So the odds against equity funds making money with long-only, long-term strategies, was roughly 9:1. Of course, a fund that picked up short-term trends could profit by fast churning because even the biggest stock market losers see short-term recoveries at various stages.
An individual investor isn't bound to long-only strategies, though most investors shudder at the thought of shorts, or using derivatives. Pretty much every trend-following analysis system suggests that the long USD and short Indian equities strategies have not yet played out.
Nor does valuation-based analysis suggest that the bear market for the rupee or Indian equity is over. RBI may be somewhat more interventionist now, and it may even cut rates in the next policy review. But the USD still looks northbound. The Euro will also jump sometime if the measures Germany is spearheading work out.
I'd prefer to see an RBI rate cut before heading into medium term debt-funds. Otherwise, if the trends persist, positive returns will be available in the next quarter mainly from short-oriented strategies. Shorts can only be taken via derivatives. If you use derivatives, whether long or short, you must consistently exercise risk control. Otherwise high leverage will wipe you out.
The easiest way to control risk, is hedged long-term options positions. Long options and option spreads have built in stop-losses. The downside is exactly limited to the initial payout. Let's say an investor decided to indulge in a long Nifty March 4000put (premium 83) in the March 2012 series.
This position costs roughly Rs 4,200 per lot (50 options) and that is the maximum loss. If the Nifty falls till 3917 before March 29, 2012, the trade theoretically breaks even. If the Nifty falls till 3,500, the trade gains 413 per option, or around Rs 20,650. That is 5:1 returns on a 35 per cent move.
The market may not fall so much. But the premium will rise anyhow if the Nifty drops closer to the strike price of 4,000. Delta calculations imply the option premium on a March 4,000 put will rise around 15-20, for every 100-point fall in the Nifty. Hence you may get a 20 per cent return on a 3 per cent fall.
This is not difficult to understand though delta calculations can be notoriously inaccurate. I think it's easier to implement this long option strategy than trying to pick bullish stocks with the odds stacked 1:9 against. If you don't like the concept of using index options and you don't want to dabble in forex, don't look for short-term gains. Keep a low profile in the equity market, until and unless the RBI does cut CRR and/ or policy rates.