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Previously in this column, we discussed delta-neutral trades setup to capture near-pure alpha returns. For instance, a long-only large-cap portfolio combined with appropriate short positions in Nifty futures. Continuing this discussion, would it be optimal to simultaneously setup opposite positions in Nifty futures and Bank Nifty futures? This week, we discuss what such a position alludes to and the practical issues you must consider before setting up the position.
Sector alpha
A long position on the Bank Nifty futures is a bet that the banking sector is poised for a likely uptrend. Nifty Index is a composition of many sectors including the banking sector. So, a long position on Bank Nifty futures and a short position on Nifty futures is a bet that the banking sector is likely to outperform other sectors in the Nifty Index.
By setting up the above position, you can capture gains in three ways. One, if Bank Nifty futures rises and Nifty futures declines. This is the most optimal scenario but is least likely to happen. Two, Bank Nifty futures and Nifty futures both rise, but Bank Nifty futures rises more than Nifty futures. And three, Nifty futures and Bank Nifty futures both decline, but Nifty futures declines more than Bank Nifty futures. Note that in the case of two and three, gains from one side of the trade will be larger than losses from the opposite side. Because this trade is a bet on a sector, the gains are referred to as sector alpha — the excess returns from sector outperformance. Note that a short position on Bank Nifty futures and a long position on Nifty futures is a bet that the banking sector is likely to underperform other sectors.
Collectively, alpha from sector bets is called sector allocation alpha. Portfolio managers who use derivatives can short sector-index futures against a long-only portfolio to capture sector alpha. Retail traders may find it difficult to capture sector alpha. For one, you must determine the appropriate contracts to go short. Suffice it to know that you must apply statistical methods to arrive at the optimal quantity. For another, you must manage this position through the expiry of the contract. Otherwise, you may have unintentional risk if the relationship between Bank Nifty futures and the Nifty futures is different than what it was in the past.
Optional reading
Generating alpha from sector bets is one of the two sources of alpha generation, the other being security selection. The sector bets of long-only managers are based on relative performance against their mandated benchmarks. A large-cap manager may overweight, say, the banking sector compared to the Nifty Index, the portfolio’s benchmark. Some investors may prefer using ETFs instead of futures for taking a long position. The issue is that an ETF on, say, the Bank Nifty may not have a stable relationship with Nifty futures, because the trading behaviour in ETFs differ significantly from that of the comparable futures.
The author offers training programmes for individuals to manage their personal investments
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