The Hindu Business Line : Harvesting betas from alternative markets

Mutual funds have not yet felt the compelling need to explore alternative asset markets, as money managers have generated alpha returns from traditional asset classes. This article argues that mutual funds should now look at alternative markets to harvest rich betas, for generating alpha from the stock market may become difficult going forward.

B. Venkatesh

Last week, this column carried an article about core-satellite approach to portfolio construction. The article argued that retail investors who do not have access to alpha generators should harvest exotic betas from the market. We received questions from readers as to where investors can explore such betas. At present, a handful of mutual funds provide exotic beta exposure. Emerging market funds and gold funds are some examples.

This article explores avenues for mutual funds to harvest exotic betas. The traditional fund structure will not be suitable as exotic betas are harvested primarily from the alternative asset markets. We, hence, recommend a modification in the current mutual fund structure to accommodate exposure to alternative asset class.

Exotic betas

Beta returns typically comes from exposure to traditional asset classes such as stocks and bonds. Exotic betas are returns generated from exotic assets such as real estate (through REITs), commodities and other alternative asset class.

As mentioned last week, exotic betas can also be generated by applying exotic trading strategies on traditional asset classes. Applying spot-futures arbitrage in the equity market is one such strategy.

Alternative asset classes have typically meant exposure in commodities. This article goes beyond such assets and recommends investing in arts, stamps, coins, private equity and any asset that has the potential to earn capital gains or generate income.

The objective is to venture into newer markets and harvest higher returns. There is obviously high asset price risk in these markets.

The above-mentioned alternative asset classes are illiquid, meaning daily closing prices are not easily available. But that has not deterred institutional investors from taking exposure to the alternative asset class.

Take the pension funds. Some US-based pension fund managers are investing in the football market in England. All teams fight for the top spot in the English Premiership League.

Each year, first division and second-division teams sell their players to clubs in the Premiership league. Pension fund mangers are buying interest in some promising stars in the lower division clubs.

Their bet is that these players can be sold for a higher price to a Premiership club at a later date. This is, indeed, a far cry from the days when pension funds invested only in fixed-income securities.

At present, the alternative asset markets, especially the private equity market, are the forte of HNIs and institutional investors. We see no reason why these investment avenues should not be open to retail investors through collective investment vehicles.

Fund Structure

How should an alternative-asset fund be structured? An open-end fund will suffer from cash drag, as it will be forced to hold cash equivalents to meet redemption requirement.

A closed-end fund is also not efficient because of the large discount that such funds trade to the NAV. Moreover, structuring as open-end or closed-end fund would force money managers to declare NAV on a continual basis. This may be cumbersome considering that the alternative assets are mostly illiquid.

It may be, hence, optimal for such a fund to list as a company on the stock exchange. Suppose a fund-house intends to invest in alternative assets. The fund-house should float a separate company, say ABC Exotic Beta Fund, and raise capital from the investor-shareholders.

The stock will be offered at par, just as with a new fund offering (NFO). The company can choose to leverage its capital.

With the amount so collected, the fund-company can buy alternative assets. Just as a closed-end fund, the company’s shares will be traded on the exchange. This provides the required entry-exit opportunities for investor-shareholders.

Importantly, it obviates the need to generate an NAV every day after the market closes. It also takes off the pressure from the money manager to maintain cash equivalents to meet redemption requirements.

The suggested structure is not entirely new. Tata Investment Corporation, though not a fund, primarily invests in shares of other companies and is listed on the NSE.

We hope that SEBI allows such a structure, for the important issue is to provide retail investors’ exposure to exotic assets. Investment in such fund-companies along with exposure to index funds will help retail investors construct the core-satellite portfolio that we discussed last week.

Mutual funds have not yet felt a compelling need to take exposure in alternative asset classes. The reason is not far to seek. With the stock market trending up since 2003, these funds have been able to generate alpha returns from traditional asset classes. The situation may be different going forward.

While there will still be some alpha generators among mutual-fund managers, most of them will find it difficult to consistently outperform the market.

Fund-houses will, hence, do well for themselves and for the retail investors by entering the alternative assets space.

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

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