Using derivatives and funds to gain

Investors have a wide array of products in the market that offer alpha and beta exposure in one portfolio. It is, indeed, unfortunate that the market does not offer near-pure alpha strategies for investors to create more optimal core-satellite portfolio. The question is: How can individuals use the products to create such strategies?

This article explains the advantage of alpha transport or portable alpha and then shows how high net-worth individuals can create such strategies using mutual funds and derivatives. It also explains the associated risks in implementing these strategies.

The core-satellite approach to portfolio management separates the alpha and the beta exposure. The core portfolio provides market or beta exposure. The satellite portfolio provides the excess returns or the alpha exposure.

But where does the alpha come from? That is the question addressed by portable alpha or alpha-transport.

It is a strategy where the investor generates alpha from any asset class through dedicated alpha-engines or vehicles.

A simple case would be an investor with beta exposure to the bond market but with alpha generated from the equity market. In this case, the alpha is transported from the equity market and placed on top of the bond portfolio. Hence, the name is portable alpha or alpha transport.

Portable alpha strategies enable investors to harvest alphas from any asset class, without regard to the asset class from which the beta is coming from. The question is: How can individuals engage in such alpha transport?

Consider an individual who prefers bonds as an asset class but wants alpha from equity. After taking the required bond exposure, the investor has to identify an alpha-generating vehicle. We will assume that the investor has identified an active mid-cap fund for this purpose.

Suppose the CNX Midcap Index generates 15 per cent return and the Midcap Fund with a beta of 1.5 generates 30 per cent. The fund is expected to generate 22.5 per cent, as it is 50 per cent more risky than the index (benchmark beta is one). The difference between the actual return and the expected returns is the alpha or excess returns.

The investor wishes to capture only this excess returns. She should, therefore, buy the active Midcap Fund and short CNX Midcap futures. This is because the mid-cap fund contains both alpha and beta exposure and the midcap futures has only the beta exposure. Buying the fund and shorting futures leaves the investor with alpha or excess returns.

Implementation

Some may question the strategy to capture only the excess return and not the fund's total returns. To reiterate, the investor does this because she does not want equity market or beta risk. What if the mid-cap index declines sharply? Taking alpha exposure amounts to taking risk on the fund manager's ability to select stocks that can outperform the midcap index.

So, even if the midcap index declines by 20 per cent, the strategy can generate positive alpha if the midcap active fund loses only 12 per cent. In this case, the fund would have generated an alpha of 8 percentage points, assuming a portfolio beta of one.

This strategy is not without risks. For one, its effectiveness depends on the statistical model employed to capture the relationship between CNX Midcap futures and the Midcap active fund. The statistical relationship while robust need not be the same as in the past. This means shorting CNX Midcap futures based on past relationship could still leave residual beta in the portfolio. For another, investors may face price risk during roll-over of the futures position .

Conclusion

Portable alpha strategies can be employed by discerning investors and by firms offering portfolio management services.

The success of the strategy will depend on the robustness of the statistical model and the ability to identify alpha-generating managers. Portable alpha strategies could be rewarding but there are implementation risks.

(The author is the founder of Navera Consulting. He can be reached at >enhancek@gmail.com )

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