The Hindu Business Line : Raising returns through overlay strategies

EVALUATING the performance of balanced funds is not easy. It is unfair on portfolio managers to compare such funds with diversified equity funds or an equity benchmark, both of which are fully invested in stocks. It is also unfair on investors to compare balanced funds to a relevant bond index. For even a small equity exposure during a market uptrend will help such funds beat the bond index.

Yet balanced funds under-performed bond funds over a five-year horizon. Viewed in the context of positive equity risk premium, this piece of statistic suggests that such funds may not be using optimal asset allocation strategy.

The purpose of this article is to propose a portfolio structure that will enhance overall returns without increasing associated risks. This involved constructing a balanced fund portfolio as a fixed-income core with equity as an overlay strategy. Employing overlay strategies, however, requires amendment of SEBI regulations to permit active non-hedging exposure by mutual funds in derivatives market.

Asset allocation: William Sharpe showed that asset allocation could explain more than 90 per cent of the variability in returns for a mutual fund. If balanced funds under-performed even bond funds over a five-year horizon, it essentially means that the dynamic asset allocation strategy employed by professional money managers was not quite effective. Another reason for the under-performance could be the constant-mix portfolio strategy.

Funds following this strategy do not perform well in a trending market because they increase equity exposure when the stock market declines and cut exposure when the market moves up.

Increasing returns from asset allocation essentially requires forecast of the directional movement in the equity and the bond markets. This is easier said than done. Given that the forecast can be wrong, it is important that portfolio managers have a substantial proportion of the funds invested in bonds. After all, the primary objective of balanced funds is to provide stable income. Yet, returns need to be enhanced.

Overlay strategy: The overlay strategy requires the professional money manager to add managed futures to the existing fixed-income core portfolio. This strategy is called an overlay because the futures portfolio can be "overlaid" on top of the fixed-income core without substantially reallocating capital. Overlay strategies have been used successfully by portfolio managers in the US to manage currency risks. It is also effectively used in creating portfolio alpha strategies.

Take, for example, a balanced fund that holds Rs 100 crore cash. Traditionally, such a fund may invest Rs 60 crore in bonds and the rest in stocks. Assume that the futures contracts provide a leverage factor of 10. The portfolio manager need invest just Rs 4 crore in managed futures to enjoy the same exposure as in a traditional portfolio that has Rs 40 crore in equity. The remaining Rs 36 crore can be invested in the fixed-income core. At the minimum, this will increase the interest component of the portfolio returns.

When the stock market is trending down and the bond market moving up, the managed-futures added portfolio would generate better returns than the traditional one because of the higher exposure to bonds. But this portfolio may perform poorly when the bond market is trending down.

The actual amount invested in the fixed-income core is the portfolio manager's decision. An aggressive fund may, for instance, take higher exposure to managed futures. The overlay strategy requires portfolio managers to additionally manage cash flows to meet the marked-to-market margin on the managed futures portfolio.

Advanced strategies can also be employed so that the overlay strategy essentially generates returns from alpha, neutralising the beta exposure. That is, of course, getting somewhat into the domain of hedge funds.

(Feedback can be sent to bvenky@thehindu.co.in)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Another dose of freedom

Analytical review of subsidies: Drawing up an alternative roadmap

An exercise in make-believe

Blunkett's exit

Raising returns through overlay strategies

The `do-good to feel-good' factor

Not ready for greatness

Relief funds: Safeguards must against misuse

Mobilise internal resources

Warning system