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Blended Investing: Generating alpha in an index portfolio (Part 1)

Since inception, investors have always been divided into 2 schools of thought – one which wholeheartedly supports market efficiency and believes no human can beat a market index in the long run. Investors belonging to this school of thought are termed as Passive investors. On the contrary, investors belonging to the 2nd school of thought or Active investors believe that the market index can be bested by 2 factors – Timing & Selectivity. So, which school ultimately wins?

“You reap what you sow”

– Investment is a game of risk & return. An index has an auto-screening mechanism by which it automatically removes weeds (poor performers) and rewards bloomers (top performers). This quarterly re-balancing doesn’t need an investor to deal with the financial health of the index constituents at all. On the other hand, an actively managed portfolio leaves all risk assessment in the hands of the investor/fund manager. This often turns out to be a double-edged sword. More bloomers in a portfolio helps the overall portfolio gain over & above the index (generate alpha) while inability to timely remove weeds might drag your portfolio to a point of no return. But what if you could take advantage of the filtering mechanism of an index and also generate alpha side-by-side?

Portable Alpha

Let’s assume that you’ve got INR 10,00,000 to invest. The NAV of an Index MF based on Nifty 50 is INR 100. The simplest choice is to invest your entire million INR in the index fund & relax. If Nifty rises by 14% in a year, your portfolio will make almost similar gains (slightly less due to the expense ratio of the fund). While you’re happy with a ~14% return, your returns over & above the index is actually 0. Thus, you’ve a 0-alpha portfolio.

The Concept of Effective Leverage

Leverage is often thought of as a double-edged sword in the world of investing. While borrowed money might help in magnifying your gains, any major draw-down might swiftly drive you to bankruptcy. However, in this case, we’re not going to exceed our initial 1 million INR limit at any instance. The margin requirement for Nifty futures varies between 12% – 15%. So, to create a notional portfolio of 1 million INR, the actual amount of money we’re going to put down is 15% of 1M = INR 0.15M (at max margin requirement). Keeping another 5% aside as a conservative buffer/Margin of safety for the variation margin requirements, we’re still left with 80% of 1M = INR 8,00,000 in-hand.

  • In case Nifty rises by 14%, the entire 14% x 1M = INR 1,40,000 will be captured by our futures portfolio,
  • Effective leverage (considering the buffer) = 1/(15% + 5%) = 5X,
  • Free capital in-hand = 80% of portfolio = INR 8,00,000.

Thus, even with just 20% of your investment, you’ve captured the entire gains your Index MF would have provided and you are already at an alpha-neutral position.

Alpha seekers

You’ve already made your portfolio alpha = 0 while keeping beta at 1. With the additional capital, you can seek to maximize alpha while limiting your beta (by lowering systematic risk). For this, you can invest in any non-equity instrument like G-secs, bonds, gold etc. (not considering cryptos as it is a highly volatile asset class). One of the best low-risk alpha seekers can be a Banking & PSU MF scheme which invests in highly rated (AAA & AA+) debt instruments issued by Banks & PSUs. With an annualized category return of 11%, you can easily capture sufficient alpha through this step.

  • Alpha captured through investment of free capital = 80%*11% = 8.8%
  • Overall portfolio returns ~ 22% (deducting ~1% for various expenses & fees)

Thus, a simple blend of derivatives and non-equity mutual funds helps you port alpha from free capital to your overall portfolio.

Is there a catch?

In our calculations, we always consider equal movement of a futures contract w.r.t. its index (delta = 1), however futures contract often incorporate a time value component which continues to decrease as it approaches maturity. Thus, effective delta might be <1 in some cases. However, this delta shortfall can be negated if the rollover cost of a futures contract is less (exiting Jan contract and entering Feb contract). How all of these add up and what can be your actual returns from a portable alpha strategy are some of the questions we are going to deal with in the 2nd part of this ‘Blended Investing‘ series.

Sneak peek into Part 2

  • An analytical exercise using Nifty 50 futures data from Jan – Dec, 2021 to obtain real-world magnitudes of rollover & various transaction costs,
  • Creating a model portfolio of INR 1M to simulate overall returns & captured alpha through a portable alpha strategy.

Stay tuned for the next part!

Sayantan Ghosh
Sayantan Ghosh

MBA (Finance), FMVA®