The Hindu Business Line : Market-neutral funds: Transporting alpha

Market-neutral funds generate alpha returns through superior security selection skills and by reducing the market risk to near-zero. Mutual funds are increasingly employing such hedge-fund like strategies for the benefit of small investors. This article shows why such funds can sit well in a satellite portfolio within a core-satellite portfolio process.

B. Venkatesh

Last week, this column discussed the replication of PMS-style products for small investors and the need for asset management firms to offer style-diversified funds. Market-neutral funds were mentioned as one such product. A reader had sent in an interesting question: Can market-neutral funds be used in a core-satellite portfolio construction?

This article shows how market-neutral funds can help small investors outperform markets without seriously violating portfolio constraints. Such funds sit well in the satellite portfolio, where the core portfolio has exposure to large-cap index funds.

The Structure

The concept for market-neutral funds is drawn from the Capital Asset Pricing Model. The CAPM shows that the expected return on a portfolio is the function of risk-free rate and average market risk-premium.

If we were to construct a model using historical portfolio returns and benchmark returns, we will get two factors (coefficients)- alpha and beta. A portfolio beta of 0.75 means that if the benchmark index moves by one point, the portfolio will move in the same direction by 0.75 point. Alpha refers to the excess returns over the benchmark index that is generated due to the portfolio manager’s skill.

Take Tata Steel. Buying the Tata Steel stock exposes the investor to firm-specific risk and market risk. If the market were to go up, Tata Steel would also go up.

The reason is because Tata Steel stock is affected by the general market movements.

Then, there is the firm-specific factor. If Tata Steel were to acquire a European firm and the news is positive, the stock price would jump-up on this firm-specific development.

A market-neutral fund that buys Tata Steel will construct the portfolio in such a way that it is exposed to firm-specific risk alone and not the market risk.

Alpha returns and risks

A market-neutral fund aims at generating alpha returns and reducing the beta risk to near-zero.

Suffice it to know that beta is a function of the correlation between the portfolio returns and the market returns and a scale-factor ratio of portfolio risk and market risk.

A market-neutral fund, hence, needs to have a low scale-factor ratio and correlation to bring its beta to near-zero. The success of the strategy rests in rightly capturing the correlation and risk factors.

The single-most important risk is, hence, the model risk. This is the risk that the model does not essentially capture the actual asset price movements.

A wrong correlation factor, for instance, can expose the fund to high beta risk. Take pairs-trading. A portfolio manager may be positive on Tata Steel but have a negative view on SAIL.

She will go long on Tata Steel and short on SAIL such that the portfolio is sector-neutral and beta-neutral.

Note that pairs-trading is a relative-value strategy in that the portfolio can benefit even if SAIL were to go up as long as Tata Steel goes up more than SAIL.

The same is the case on the downside. This strategy will be, however, profitable only if the model rightly captures the co-movement between Tata Steel and SAIL.

portable alpha

Take an investor who does not want exposure to the equity market. A typical portfolio would contain bond mutual funds, term-deposits and some tax-savings investments such as Public Provident Fund (PPF). The portfolio advisor can recommend market-neutral funds despite the portfolio constraint against stocks. Here is why.

Suppose a portfolio manager constructs a mid-cap portfolio with Sesa Goa, Engineers India, Hotel Leelaventure, Tata Chemicals, Marico and Petronet LNG. Her security selection process will depend on whether she believes a mid-cap stock will outperform the benchmark index. She will then short mid-cap index futures to back-out the market risk from the portfolio.

It is important to understand that a market-neutral fund is not a pure-alpha fund. It will still contain some residual beta, as beta exposure cannot be fully neutralised. Nevertheless, such a fund can be used to enhance risk-adjusted returns in a portfolio that limits equity.

By recommending a market-neutral fund, the portfolio advisor can help the investor transport alpha to the portfolio without seriously violating any risk constraints.

This process of transporting alpha from another market segment is called portable alpha or alpha-transport.

A market-neutral fund fits well in a satellite portfolio within a core-satellite portfolio process. The core portfolio could consist of large-cap index funds, which is pure beta exposure. The satellite portfolio would consist of funds that generate alpha and exotic-beta returns.

Conclusion

Market-neutral funds have traditionally been the forte of hedge funds. This article shows how small investors can be benefited by replicating this strategy. JP Morgan Asset Management has filed an offer document with SEBI for a proposed Alpha Fund. It is imperative that asset management firms in India offer more such hedge-fund like products for small investors.

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

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