A long-short fund runs 150% long and 50% short on Rs 400 crore of NAV. Its shorts are squeezed up 40% while its longs fall 5%. What does NAV lose, and what does that say about gross exposure?

NAV falls by Rs 110 crore, 27.5%, although net exposure was only 100%. The longs lose Rs 30 crore and the shorts Rs 80 crore. A long-only fund would have lost 5% on the same day. When longs and shorts both move against the fund, gross exposure, not net, sets the damage; afterwards the book is 293% gross on a smaller NAV, and trimming the shorts means buying at squeezed prices.

Take each side separately. Longs: Rs 600 crore falls 5%, a loss of Rs 30 crore. Shorts: the fund sold Rs 200 crore of stock it does not own, and that stock is now worth Rs 280 crore, so buying it back costs Rs 80 crore more than the fund received. Together the fund loses Rs 110 crore, 27.5% of NAV, more than five times what a long-only fund with the same net exposure would lose. Notice that the short side, only a third of the gross book, did almost three quarters of the damage, because a short loses more the further a price rises, with no ceiling.

Net exposure assumes the longs and shorts offset each other: when the market falls, the longs lose and the shorts gain. Think of a trader who owns an umbrella shop and bets against a raincoat shop across the road: if it rains, one gains and the other loses. A squeeze breaks that assumption: the fund's longs fall and its shorts rise in the same week, so both sides lose, and gross exposure, the sum of the two, measures the money at risk. CrowdingWhen many funds hold the same positions, so they are forced to buy or sell together and move prices against themselves. makes it worse: the shorts were popular with other funds, so everyone covered at once, and the longs were the liquid names everyone sold to raise cash.

Worse than before. Longs are now Rs 570 crore and shorts Rs 280 crore, on NAV of Rs 290 crore. That is 197% long and 97% short, 293% gross, so the fund is now far more levered than it chose to be, with the shorts almost doubled as a share of NAV. The prime broker is likely to demand more margin. Getting back to 50% short means buying back about Rs 135 crore of stock that has just risen 40%, which can push those prices higher still.

Four, each aimed at the mechanism. A gross exposure limit, not just a net one. A cap on any single short, because losses on a short are unbounded. A crowding check: short interest in each name and the number of days the market would need to cover it. And a stress test that moves longs and shorts against the fund together, not in the usual offsetting way. The lesson for the interview: net exposure tells you your market bet; gross exposure tells you how much you can lose when your hedges stop hedging. The limitation is that a 40% move across a whole short book is extreme; it happens when shorts are concentrated and crowded, which is exactly what the limits are there to prevent.