Markets valuations are above historical average, so where should investors put their money?

Alternative investment funds (AIFs) have been gaining traction in the country with the increase in the number of ultra high networth individuals (UHNIs). Data available with the market regulator Sebi shows that total investments in AIFs stood at Rs 4.32 lakh crore in the June quarter, up 39% year-on-year. Out of that, investments in category III AIFs, which need a minimum investment of Rs 1 crore, witnessed 73% YoY growth with the assets under management (AUM) at Rs 1.13 lakh crore in Q1FY24. As benchmark indices like Sensex and Nifty hit record highs, how can HNIs grow their wealth and manage risks? In a conversation with Business Today, Puneet Sharma, CEO and Fund Manager of Whitespace Alpha, a category III AIF, shared his thoughts on AIFs, current market trends, risk management, promising sectors, and more. Edited excerpts:

Q) Can you explain what a Category III AIF is and how it differs from other categories?

Puneet Sharma: A Category III AIF is a specialised type of fund in India that focuses on high-risk, market-driven strategies such as long-short equity positions, derivatives, leverage, and arbitrage. These funds are distinct from Category I and Category II AIFs, which tend to focus on long-term, lower-risk investments like infrastructure, social ventures, or private equity.

The key difference lies in their investment approach. Category III AIFs are designed to generate short-term capital gains by actively trading in publicly listed securities. They are also allowed to use leverage, meaning they can borrow money to amplify returns, which inherently increases the risk. In contrast, Category I AIFs target socially beneficial projects like start-ups or infrastructure, and Category II AIFs focus on private equity and debt, neither of which can use leverage in the same way.

Q) What types of investors typically invest in Category III AIFs?

Puneet Sharma: Investors in Category III AIFs are typically HNIs, family offices, and institutional investors who have a higher risk tolerance and seek potentially higher returns. These investors are sophisticated, able to understand the complexities and risks involved in high-leverage strategies, and are comfortable with the possibility of market volatility.

Q) Markets are trading at record highs, how do you see the trend going ahead?

Puneet Sharma: Indian markets are currently trading at a P/E ratio of 27.25, which stands significantly above the historical average of 22-23. This elevated valuation signals one of two potential outcomes: either we witness a substantial uptick in corporate earnings to justify these high levels, or the market may undergo a necessary correction to bring valuations back in line.

Given these circumstances, it is prudent to focus on large-caps with strong fundamentals and resilient business models. These firms, with their robust balance sheets and proven track records, are more likely to weather market volatility. Moreover, in such overvalued environments, passive investment strategies that track large-cap indices offer an efficient way to capture market gains while mitigating the risks inherent in active management.

In a market stretched by valuation, passive strategies that emphasize quality, stability, and cost efficiency become even more compelling, especially as they sidestep the challenges of timing corrections in an overheated market.

Q) What investment strategies does your fund employ, and how do they align with current market trends?

Puneet Sharma: Whitespace Alpha employs a passive investment strategy, focusing on topping off returns with low-risk derivative strategies. This approach allows the fund to achieve consistent performance with minimal market exposure. Given the current market environment of high valuations, this strategy is particularly relevant as it mitigates the challenge of delivering alpha through traditional active management.

By leveraging derivatives such as options and futures, the fund minimises risk while still capturing upside potential, without needing to take on significant directional bets. This aligns with current trends where passive investing is gaining traction, particularly in India, as investors look for cost-efficient and risk-averse methods to navigate market volatility.

The fund’s focus on derivatives further complements its strategy, providing a buffer against downturns while maintaining stable, incremental returns. Given the increasing difficulty for active managers to outperform benchmarks in a high-valuation market, this strategy positions Whitespace Alpha to consistently outperform by maintaining a conservative yet opportunistic stance.

Q) How do you manage risk within the fund?

Puneet Sharma: Our proprietary risk models constantly monitor market conditions, helping us proactively manage risk by identifying potential threats or opportunities in real-time. We enforce strict position sizing to avoid overexposure to any single stock or sector. This helps mitigate concentration risk and ensures a balanced, diversified portfolio.

We have a robust system in place to continuously monitor Value at Risk (VaR), which helps us quantify potential losses over a specified period under normal market conditions. By monitoring VaR, we can ensure that risk levels stay within acceptable limits, preventing unexpected shocks to the portfolio. We use derivatives like options and futures to hedge our positions, which helps limit downside risk. This approach gives us the flexibility to adjust exposure dynamically without taking on excessive risk.

Q) What are some key sectors or industries that your fund is currently focused on, and why?

Puneet Sharma: At Whitespace Alpha, our strategy is deliberately sector-agnostic and focused on achieving consistent returns through market-neutral investing. We invest exclusively in benchmark indices and AAA-rated government bonds, steering clear of concentrated bets in any specific sector. This approach allows us to capture the broader market’s performance without being exposed to the volatility that often accompanies sectoral investments.

By holding blue-chip stocks tied to benchmark indices, we align our portfolio with the overall market, while AAA-rated government bonds provide a layer of stability and risk mitigation. These bonds ensure reliable income streams and safeguard the fund during periods of market turbulence.

Our investment philosophy is to remain long on growth while managing risk effectively through market-neutral strategies. This allows us to navigate fluctuations and corrections with minimal volatility, ensuring that our investors benefit from a steady, well-balanced portfolio without sector-specific risks.

Q) What kind of liquidity options do your investors have, and how important is liquidity management in your fund?

Puneet Sharma: For the Equity plus fund, we offer a 36-month lock-in for most investors, but those investing more than ₹1.25 crore enjoy no lock-in period, giving them the freedom to move capital with ease. The Debt plus fund offers monthly liquidity, making it ideal for investors who value immediate access to their funds. In the Hybrid plus fund, liquidity is managed through a graded exit load—2% within the first year, 1% between 12-24 months, and no exit fee after 24 months.

What truly sets us apart is our emphasis on liquidity management. We’ve developed proprietary systems to ensure that we can liquidate positions when needed, even under stressed market conditions. This is essential for preserving value and maintaining stability across our portfolios. By investing in high-quality, liquid assets, we ensure that investor redemptions are met without disrupting market pricing or overall fund strategy.

At the core, liquidity management for us is not just a process—it’s about providing peace of mind to our investors, ensuring they have access to their capital whenever they need it while maintaining the integrity and performance of the fund.

Q) What has been the fund’s performance over the past few years, and how do you plan to sustain or improve that performance?

Puneet Sharma: Over the past few years, the fund has consistently beaten market benchmarks, delivering an average 10-12% alpha annually. For instance, in 2023, we outperformed the Nifty 50 by approximately 11.6%, showcasing our ability to generate superior returns even in challenging market conditions.

Looking ahead, we plan to stick to this strategy—riding out any potential corrections, as the market will likely revert to delivering 12-15% annual returns once the current high-valuation phase stabilizes. Our focus remains on long-term, stable gains, ensuring that the fund continues to outperform while maintaining a low-risk profile.

Innovation plays a key role in our approach. By continually refining our proprietary models and staying at the forefront of data-driven strategies, we remain agile, capturing market inefficiencies with precision. This combination of innovation and discipline positions us to consistently outperform, even in fluctuating market environments.

Q) How much return one can expect from category 3 AIF in the long run (say 5 years)?

Puneet Sharma: In the long run, typically over a period of 5 years, investors in Category 3 AIFs can expect annualized returns ranging from 12% to 16%, depending on the fund’s specific strategy and risk profile. Category 3 AIFs often employ complex strategies such as leverage, derivatives, and long-short positions, which can generate alpha beyond traditional benchmarks like the Nifty 50.

However, the exact returns depend significantly on the type of Category 3 AIF. Some funds may aim for higher-risk, higher-reward strategies, potentially delivering returns at the upper end of the range, while others focus on more conservative approaches that still outperform benchmarks but with lower volatility. The combination of active management and sophisticated strategies typically allows these funds to generate better risk-adjusted returns over time, but market conditions, leverage, and the fund’s specific focus play a critical role in shaping the actual returns.