Equity Management #11 : Alpha Transport with Derivatives

First, a short personal update, I am still acclimatising myself to a 9 to 6 routine and struggling with a 6.5 hour daily sleep cycle so I am still tired after work. Given time, I should be able to return to my old blogging momentum.

So far, I am enjoying my internship. At least I can spend my time on public transport reading investing books and not some legal case or textbook. I don't miss reading legal cases because that's what I do in the office all day !

Anyway, today I only have a short insight to share which is the idea of an Alpha transport with Derivatives.

a) Defining Alpha Transport

This is basically the idea that you can combine long positions in equities with short positions to generate alpha which is superior performance arising from better stock picking skills. This alpha can then be transported to another portfolio which is an optimised based on different asset classes.

b) Derivatives

There is this opposing idea that most portfolio returns do not come from stock picking but from asset allocation. For example, you can have a decent enough portfolio when you construct your portfolio using ETFs in a 60/40 proportion in equity/bonds and you will not really make very much more by cherry picking your stocks.

One effective way of constructing a portfolio which gives average index returns is to buy futures or options. For example, a future on DJIA derives it value from how much the index is currently doing.

There is even a way of replicating an index using swaps.

c) Alpha Transport + Derivatives

The book proposes that a long-short portfolio be combined with a series of derivatives which are created to simulated index returns.

This way you can get the best of both worlds. An optimal asset allocation between stocks and bonds as well as the opportunity to select stocks for superior performance.

d) Shortcomings of long-only fund managers

This might be useful for regular readers of financial blogs. Alpha Transport with Derivatives is an alternative to the traditional active fund manager.

The first shortcoming of fund managers and quite a few super-serious financial bloggers is that the work put in to think about just one stock counter is quite labor intensive. Some analysts start with SWOT analysis and look at the industry the stock is in and then they drill into various accounting ratios to determine whether a stock should be bought. The labor intensiveness of this form of fundamental analysis hurt these fund managers because it limits them to a small pool of investible counters. The consequences may also include under diversification. This makes FA quite unwieldy for retail investors.

The second shortcoming is that traditional active management is super-subjective. How do you know that management is great ? What makes you think that the industry is going to survive technological disruption ?

To a certain extent, I deal with this problem by reading second hand research I can find from the web and polling the thoughts of other bloggers. I can possibly comb through 5-6 reports a day. The other way I deal with the problem is to simply ignore reports on stocks which do not provide at east 6% dividend yields.

In my next talk, I will show you guys a quick and dirty way to create a system that generates stock picking suggestions so that you will always have more investment ideas than the money you have for making investments.