The Hindu Business Line : Generating portable alpha through arb funds

JM Equity and Derivatives Fund is an arbitrage (arb) fund that generates profits from mispricing of assets in the spot and the futures market. This fund can help investors gain exposure to portable alpha. Such alpha strategies are typically exploited by hedge funds. Other fund-houses may soon introduce such arb funds to offer their choice of competing products. Over the longer time, however, fund houses need to introduce diverse structured products to provide investors a range of portable alpha strategies.

Portable alpha: A portfolio manager's performance is typically benchmarked to an index. Regressing the fund returns on the benchmark outputs the portfolio beta and the alpha. In traditional portfolio management, the professional money manager may be taking unintentional beta bets just to generate the alpha. Exchange-traded and OTC derivatives has fortunately changed this approach to portfolio management.

Suppose the S&P CNX Nifty matches the horizon objectives of a certain investor. Traditional portfolio management would mean buying an index fund with low management fees and tracking error or buying all the stocks constituting the index. The portfolio manager in this case can generate excess returns only by timing the buy/sell decision. An enhanced index fund follows this strategy.

A portable alpha strategy can be structured as follows: The portfolio manager will apply, say, 70 per cent of the assets to buy index futures and engage in futures roll till the horizon. This will provide the investor the core exposure to the benchmark. About 10 per cent of the portfolio will be investing in cash to provide mark-to-market margin on futures. The remaining 20 per cent will be invested in alpha-generating assets. This can be a market-neutral fund, which takes simultaneous long-short positions in various securities such that the portfolio beta is near zero. A fund may, for instance, short TVS Motors and buy Hero Honda so that the paired beta is near zero. The alpha will be generated from relative mispricing of the two securities.

The important point is that the alpha need not be generated from the core strategy. It can be generated from any asset and `ported' into the core strategy. An investor with a fixed-income core can generate alpha from equity strategies. If the alpha is not generated from market-neutral strategies, the portfolio manager will short appropriate index futures to neutralise the beta exposure.

Alpha management: JM's arb fund can generate portable alpha because it is essentially a market-neutral fund. This fund can, hence, combine well with fixed-income funds or equity index core. But porting alpha into a core strategy also transfers the associated risks. An arb fund suffers from the following risks:

One, the basis is volatile. The standard deviation of the daily basis on the index is 7.6 per cent. The basis volatility is likely to be higher for single-stock futures. A portfolio manager relying only on statistical models could expose an arb fund to model error risk. And two, the portfolio manager will be under pressure to generate higher returns if the paired trades are held till futures expiry.

The reason is that the capital locked in the pair trades suffers opportunity cost of at least 5 per cent, which is the average fixed deposit interest that investors earn. The high return criterion for holding pair assets till horizon may constrain the manager from aggressively exploiting asset mispricing.

Notwithstanding this fact is JM's arb fund allows small investors to take exposure in portable alpha strategy. Even risk-neutral investors should attempt to carve a small portion of their existing portfolio to construct a core plus the alpha strategy.

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

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