The Hindu Business Line : Active extensions: Harvesting alphas on upside and downside

This article looks at harvesting alphas on either side of the market. Called active extension, this strategy helps investors and portfolio managers optimally exploit their positive and negative views on assets. The article also presents a strategy called modified fence for retail investors.

B. Venkatesh

The secular uptrend in the market has been arrested for over a month now. Portfolios of most institutional and non-institutional investors have suffered large losses since this January. Yet, the sharp decline in asset prices on January 21 and the wobbly market since then has been good news for some investors — those who were short Nifty futures or long on Nifty puts. This is a testimony for investors who do not believe that returns can be harvested on the downside as well.

This week, we focus on a strategy that can generate alpha on either side of the market. We call it modified active extension and style it on the lines of the popular active extension strategy, also called beta-one fund.

Long-only strategy

Professional money management is typically a long-only strategy. Take a mid-cap fund. The portfolio manager is benchmarked to the CNX Mid-cap index. Suppose the portfolio manager has a positive view on Balrampur Chini but carries a negative view on Bajaj Hindusthan.

The portfolio manager has two choices as far as Bajaj Hindusthan is concerned. She could underweight the stock in the portfolio. Suppose the stock carries 0.70 per cent in the index, she may choose to have only 0.10 per cent weight in her portfolio. The second choice would be to have no exposure in the stock. Typically, this would depend on how much weight the stock has in the index and what tracking error the portfolio manager is allowed.

In either case, the manager is not optimally using her view on the assets. Ideally, she should have gone long on Balrampur Chini and short on Bajaj Hindusthan. She could not construct such a portfolio because of the long-only constraint.

Active extensions

In active extension strategy, the portfolio manager can set-up a position to take advantage of her view on both the stocks. The portfolio can now generate alpha returns on either side of the market. The most preferred strategy is 130/30. The portfolio manager will invest 100 per cent of the assets in mid caps just as a long-only manager does. She will go short on mid-cap stocks on which she has a negative view to the extent of 30 per cent of the assets.

She will borrow stock from the broker to deliver against the short positions. Then, she will borrow cash or use the proceeds from the short-sale to buy 30 per cent more of mid-cap stocks on which she is positive.

The portfolio will, thus, have 130 per cent exposure in longs and 30 per cent exposure in shorts and sometimes 30 per cent borrowings. The net long in the stock market is only 100 per cent.

The 130/30 strategy will be subject to all other constraints such as beta exposure, sector caps and individual exposure caps, just like a long-only fund. Note that the active extension strategy can be 120/20 or even 140/40, as long as the net long is 100 per cent.

Professional money managers who run separately-managed accounts in brokerage firms and investment banks and as well as discerning investors can apply this strategy to generate alpha returns.

Modified Extensions and fence

Active extension strategies are not possible till our market has well-established stock-borrowing mechanism. Money managers and HNIs can instead use futures to take short positions.

The long exposure in the stocks can be used as collateral for the short futures position. Of course, the entire portfolio cannot be invested in longs, as the money manager will need cash to meet the mark-to-market margin on short futures. The cash drag on the portfolio will be, however, compensated by the alpha returns generated on the short futures.

Retail investors cannot benefit from this strategy, as the asset size required to optimally implement the strategy is likely to be large. The best that retail investors can do is to implement what we call as “modified fence”.

A fence is a strategy where a trader holds the underlying and buys lower-strike puts and sells higher-strike calls on it. In a modified fence, the puts and calls will not be on the same underlying.

Suppose a retail investor holds 75 shares of Reliance Industries. She will write 2,400 calls on Reliance and collect Rs 4,950 as premium.

The shares can be offered as collateral for the short calls. The premium collected can be used to buy 930 puts on ICICI Bank on which she has a negative view. The total outlay will be Rs 5,775. This strategy helps the retail investor take positions on both sides of the market.

It is important for investors to set up long and short exposures to optimally exploit their view on assets and consistently outperform the market. We believe that modified active extension would be a good strategy to harvest alphas.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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