Delta-neutral trades can be setup to gain from positive gamma and positive vega involving two different option strikes or negative theta, involving the underlying and an option. Beta-neutral trades, on the other hand, are meant to capture near-pure alpha. This week, we discuss a beta-neutral strategy and how professional money managers setup such positions using futures contracts.
Alpha is the returns differential between an active portfolio and its appropriate benchmark index. For instance, if a large-cap active fund, generates 13 per cent in a year and the Nifty 50 Index, its benchmark, generates 12 per cent during the same period, the fund’s alpha is one percentage point.
Professional money managers sometimes prefer to capture only a portfolio’s alpha. To do this, they must cancel the portfolio’s beta. Why? A portfolio that is long on, say, large-cap stocks is long on, both systematic risk and non-systematic risk. Note that the compensation for systematic risk, is market returns, whereas, the compensation for non-systematic risk is alpha. Therefore, money managers who want only alpha, must eliminate systematic risk and intentionally keep non-systematic risk in their portfolio.
Systematic risk can be eliminated using futures contract on the appropriate (style) benchmark. This is because an index has only systematic risk. Therefore, a futures contract on the index must also contain only systematic risk. In the above case, money managers will short Nifty futures contracts against the large-cap portfolio, to capture the portfolio’s alpha.
The number of contracts that a money manager must short, is based on the portfolio value, the futures price, its permitted lot size, and the current beta of the portfolio. Put simply, the money manager’s objective is to make the portfolio market-neutral. The objective is to generate alpha regardless of the market direction.
As with delta-neutral trades discussed previously in this column, the issue is that market-neutral positions must be actively managed. Otherwise, the position could be unintentionally exposed to market risk. This will happen when Nifty futures contract does not exhibit the same relationship with the portfolio as it did in the past. Adjusting the short contracts continually, can lead to high transaction costs and tax incidence. These costs can be higher, when futures contracts on the portfolio’s benchmark is unavailable. Money managers must, therefore, trade-off these costs with the position drifting away from market-neutrality. That is why these strategies are positioned as near-pure alpha strategies, indicating that there will be some beta in the portfolio (referred to as residual beta).
The above discussion was intended to show how index futures can be used to create market-neutral strategies. Retail traders may be unable to capture such gains, if they were to go long on, say, a large-cap active fund and short appropriate number of Nifty futures contracts. This is because the associated transactions could be high, not to mention the time and effort required to actively manage the short position to maintain market neutrality.
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