Adding Alpha Without Adding Risk

By Daniel McNulty AAA

There are many strategies that involve the use of futures to increase returns. The majority of these strategies increase returns to your portfolio by increasing your exposure to volatility. Many of these theories are based on the efficient market theory and use a complex method of measuring volatility, correlation and excess return along with other variables to construct portfolios that fit a particular investor's risk tolerance while optimizing theoretical return. This is not one of those strategies. Read on to learn about another way of generating higher returns without changing the risk profile of your portfolio.

TUTORIAL: Futures 101

Alpha, What's That?
Alpha is what would be deemed "excess return." In a regression equation, one part describes how much the market's movement adds to your portfolio's return; the remainder of the return is deemed alpha. This is a measurable way to gauge a manager's ability to outperform the market. (To learn more, see Understanding Volatility Measurements.)

Breaking the Rules
In finance, risk usually is believed to be correlated positively with returns. This strategy represents an exception to that rule. Large portfolios that hold shares of an index, like the S&P 500 index, can be manipulated to represent the original allocation of equity with less capital allocated to that position. That excess capital can be invested in U.S. Treasury bonds or Treasury bills (whichever fits the investor's time horizon) and put to use to generate risk-free alpha.

Keep this in mind, the portfolio must have at least one core position with a corresponding product available in the futures market in order for this strategy to be implemented. This strategy would not be considered active management, but does require some monitoring in case of margin calls, which we'll cover in more detail later on. (For more, check out Bettering Your Portfolio With Alpha And Beta.)

The Traditional Cash Portfolio
In order to understand this strategy, you must first understand what we are emulating. Below we will examine a traditional, and rather conservatively allocated, portfolio.

Suppose that we have a $1 million portfolio and we want to allocate this portfolio to reflect a mixture of 70% U.S. Treasury bonds and 30% of overall equity market. Since the S&P 500 is a rather accurate gauge for the overall equity market and has a very liquid corresponding product in the futures market, we will use the S&P 500.

This results in $700,000 in U.S. Treasury bonds and $300,000 in S&P 500 shares. We know that U.S. Treasury bonds are yielding 10% per annum, and we expect the S&P 500 to appreciate by 15% in the coming year.

We can add up these individual returns and see that our returns for this portfolio would be $115,000, or 11.5%, on the portfolio over the year.

Controlling Something Big with Something Little
Knowing how the basic principles of futures contracts work is essential to understanding how this strategy works. (For a basic explanation of futures, see The Barnyard Basics Of Derivatives.)

When you take a futures position worth $100,000, you do not need to put up $100,000 to be exposed to it. You only have to hold either cash or near-cash securities in your account as margin. Every trading day, your $100,000 position is marked to market and gains or losses on that $100,000 position are taken from or added directly to your account. The margin is a safety net your brokerage house uses to ensure that you have the cash required on a daily basis in case of a loss. This margin also provides an advantage for setting up our alpha-generating strategy by providing exposure to the original $1 million position without having to use $1 million of capital to do so. (For more insight, check out the Margin Trading tutorial.)

Implementing Our Strategy
In our first position, we were seeking an asset allocation of 70% U.S. Treasury bonds and 30% S&P 500 shares. If we use futures to expose ourselves to a large position with a much smaller amount of capital, we suddenly will have a large portion of our original capital unallocated. Let's use the situation below to put some values to this scenario. (Although margin will vary from country to country and between different brokerages, we'll use a margin rate of 20% to simplify things.)

You now have:

  • $700,000 in U.S. Treasury bonds
  • $60,000 in margin exposing us to the $300,000 worth of S&P 500 shares via futures ($60,000 is 20% of $300,000)

We are now left with an unallocated portion of our portfolio valued at $240,000. We can invest this leftover amount in the U.S. Treasury bonds, which are inherently risk free, at their current annual yield of 10%.

This leaves us with a $1 million dollar portfolio that has $940,000 in U.S. Treasury bonds and $60,000 allocated to margin for S&P 500 futures. This new portfolio has the exact same risk as the original cash portfolio. The difference is that this portfolio is able to generate higher returns!

  • $940,000 in U.S. Treasury bonds yielding 10% = $94,000
  • $300,000 (controlled by our $60,000 futures margin) of S&P 500 shares appreciate by 15% to generate a return of $45,000
  • Our total gain is $139,000, or 13.9%, on our total portfolio.

The gain on our original cash portfolio was only 11.5%; therefore, without adding any risk, we have generated an additional return, or alpha, of 2.4%. It was possible because we invested the leftover, unallocated, portion of our portfolio in risk-free securities or, more specifically, U.S. Treasury bonds.

Possible Problems
There is one major problem with this strategy: even if investor is correct about where the S&P 500 will be in one year's time, within that year, the price of the index can prove to be quite volatile. This can lead to a margin call. (For related reading, see What does it mean when the shares in my account have been liquidated?)

For example, using our scenario above, suppose that within the first quarter, the S&P 500 declines to a level at which the investor must pay out part of his or her margin. Now, because we have a margin rate of 20%, some amount of capital must be reallocated to keep this position from being called away. Because the only other source of capital is invested in U.S. Treasury bonds, we must liquidate a portion of the U.S. Treasury bonds to reallocate the necessary capital to keep our margin at 20% of the future's total value. Depending on the magnitude of this drawdown, this can have a material effect on the overall return that can be expected in this situation. When the S&P begins to rise and the margin allocated exceeds 20%, we can reinvest the proceeds in shorter term Treasury bills, but assuming a normal yield curve and a shorter investment horizon, we are still making less on the U.S, Treasury portion of the portfolio than we would if the strategy had gone as planned and the S&P had been less volatile.

Other Applications
There are several ways that this strategy can be used. Managers that head up index funds can add alpha to the returns of their fund by using this strategy. By using futures to control a larger amount of assets with a smaller amount of capital, a manger can either invest in risk-free securities or pick individual stocks that he or she feels will generate positive returns to add alpha. Although the latter exposes us to new idiosyncratic risk, this is still a source of alpha (manager skill).

Bottom Line
This strategy particularly can be useful to those who wish to simulate the returns of a given index but wish to add a level of protection from the alpha (by investing is risk-free securities) or for those who wish to take on additional risk by taking on positions exposing them to idiosyncratic risk (and potential reward) by choosing individual stocks they feel will generate positive returns. Most index futures have a minimum value of $100,000, so (in the past) this strategy could be used only by those with larger portfolios. With the innovation of smaller contracts like The S&P 500 Mini®, some less-endowed investors are now able to implement strategies once available only to institutional investors.

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