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A dose of Alpha for your portfolio

Anil Rego  |  Mumbai 

Some clues on what to do when there is no, or unclear, trend

When things move without a direction, back and forth, it can get frustrating for an active equity enthusiast. Nobody really knows for how long the consolidation could last, whether markets will break out or break down. How does one outperform the index and also protect capital?

RANGE-BOUND VS TRENDING MARKETS
The markets had dunked to low levels around October 2008. The almost bottomed and continued to oscillate between 2,525 in October 2008 and 3,020 in March 2009, before moving up to over 4,000 levels. The other range-bound movement was more recent and lasted for close to nine months between 5,000 levels in November 2009 and 5,375 in July 2010. A movement of just 375 points over a nine-month period is painful to watch. On the other hand, the market was trending well between March and June of 2009.

Studying the possible resistance levels that one could use for buying or booking profits is important. The strategy one adopts in a trending market is different from that he adopts in a sideways market. While buy and hold works well in a trending market; buy low, sell high works well in a sideways market.

WHILE SEEKING ALPHA
Everything boils down to the fact how much return we are able to generate. Alpha, by definition, “is a risk-adjusted measure of the so-called active return on an investment”. It is the return in excess of the compensation for the risk borne and, thus, is commonly used to assess active managers' performances.

The concept: comes from observations made during the middle of the 20th century. It was seen that someone, who simply invested in every stock in proportion to the weight it occupied in the overall market in terms of or indexing, made more money than investment managers.

 
BSE sectoral indices
In % Y-o-Y % Change YTD
2007 2008 2009 2010
Cons durable 94.63 -72.49 97.8 56.11
FMCG 19.94 -14.33 40.46 24.22
Healthcare 16.52 -32.87 69.18 13.17
Cap goods 117.33 -65.02 104.26 6.93
Metal 121.47 -73.95 233.68 -7.29
Source: BS Research Bureau

Returns are always studied in line with risk. Hence, one needs to relate (return) to (risk) to at risk-adjusted levels.

Sectoral Allocations: Sectors have different cycles. Some perform well during a downtrend or a sideways market while others follow a slightly predictable cycle and do well in a market trend. As indicated in the table (BSE sectoral indices), while the metals and consumer durables sectors tanked the most during the downtrend, FMCG and healthcare held their mettle and have not necessarily been too buoyant during the uptick. However, amongst the laggards during the downtrend, consumer durables has been the top performer during the current uptick.

Derivatives positions: One can use options and futures to take ‘risk’. However, hedge positions (positions in derivatives) can be used predominantly to de-risk the In a range-bound market, one cannot conclusively take a certain position. By going long, he may run the risk of a market breakdown and in such a case, he could write a put on his holding, thereby protecting his downside. If he is completely short in the spot market, then he would run out of luck if the market makes continuous upsides. Here he can write a call, thereby taking an equal and opposite position in the derivative market.

In fact, he can do the same by means of taking positions in futures or mini futures. However, instead of a put (right to sell) or call (right to buy), he will simply go the long (buy) or short (sell) on these instruments.

WHEN VALUATIONS GET STRETCHED
Go for dividend yielding stocks: In a stingy market, their stable businesses and guaranteed returns from their dividends as suggested by their healthy financials, dividend track record could well be your best bet.

Glittering gold: Gold was the only instrument which provided positive returns when all hell broke loose. Gold is known to have an inherent inverse relationship with the dollar and the breakdown in the equity markets happened when the subprime crisis reached its prime. Gold will hold its ground in such tedious times, a safe haven.

Writing covered call options: A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. This strategy is often called ‘buy-write’, since he buys the underlying instrument at the same time as he sells the call.

This is a conservative strategy of taking money up front in exchange for capping your gains. Selling/writing these calls, we cap the gains but collect the option premiums up front, thereby conservatively making some decent dough. It is conservative since we are merely selling the options and the buyer of such options is the one who is speculating.

It is important to understand whether a market is range-bound or trending if one wants to deliver In a trending market, one can use sectors that are perceived as higher-risk ones and in a sideways market, some of the strategies such as picking dividend yield stocks and defensive sectors will be useful. As markets do reach highs, it is a good idea to also start derisking in a phased manner and a gradual move into lower risk sectors and funds is advisable.

The writer is CEO, Right Horizons

First Published: Sun, September 12 2010. 00:24 IST
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