A good strategy that smart and lucky traders can use in this market. Read on...
The concept of index investing is very simple. The stock market outperforms other assets over the long-term. It is possible to beat the broad market through active investing. But the more efficient the market, the more difficult it is. Hence, the safest route to prosperity is a passive investment strategy.
The strong statistical evidence in favour of this, has led to the worldwide success of index funds and ETFs. A systematic investment plan gives decent returns. However, traders and investors have also devised various clever strategies that attempt to generate market-plus returns while still sticking to the ambit of the index.
Here are some of those strategies.
The simple ones involve mechanical filters such as the “Dogs of the Dow” strategy. In this, the investor buys the stocks with the highest dividend yield (usually price-underperformers). At the end of each year, the dividend is collected and the stocks with highest price-appreciation are replaced with a new set with high dividend yields.
This strategy has sound logic to it. A dividend-paying stock is usually a viable business. The yield is a cushion against price-depreciation – especially in India, where it’s tax-free. Other mechanical filters such as lowest PE, PBV, etc, can be used instead.
The turnover-weighted (TO) index is another popular mechanical filter. The weights in a turnover-weighted index differ from a standard market-cap weighted index. TO- Indexing gains where large under-valued businesses are positively re-valued. Market-cap-indexing gains when small, high-growth companies are consistently awarded high valuations.
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There are also trading mechanisms, which attempt to ride indices and score market-plus. For example, it is possible to create combinations involving index derivatives. Let’s say, a trader has a corpus of Rs 5 lakhs and he wishes to beat the index return without straying too far away from the index itself.
Instead of investing in an Index Fund, the trader can buy index futures and put the remaining money into a liquid fund. Typically, around 15-20 per cent would be required as margin for the futures position (inclusive of rollovers). (It would be much less for long calls). The liquid fund’s yield, whatever that may be, is a guaranteed positive return.
If the market rises, the leverage on the futures position will produce at least the same returns as a Rs 5 lakh position in an index fund. If the market falls, the losses will be the same as occur with Rs 5 lakh index fund investment.
In both situations, the liquid fund return is positive excess over market. In case of losses the futures positions are booked as losses on each rollover. But there is a chance that a losing index fund will eventually come back to the black. With profits, the taxes are short-term capital gains. Losses and profits can be written off versus each other.
Over any given period, the liquid fund+ futures strategy does well. It is possible to buy mid-month month futures or six month options for that matter. So, the losses may be exactly limited, while the upside remains excellent. But the index fund is an asset that can be held indefinitely and so, it’s safer versus the wasting asset.
A complex variation on the theme is to invest that entire amount in an index fund and then borrow against it. If you borrow against an ETF, you could get up to around 90 per cent of the value, at high interest, of course. It is also possible to borrow against a liquid fund holding of course. But this strategy hopes that the ETF return will beat the return on the liquid fund. The borrowed cash is put into long futures or long calls.
This is a “long-long” strategy. If the market goes up, your returns will be magnified by well over 400 per cent after interest costs. If the market dives, the interest costs will add to the loss of the borrowed capital. There is no risk of default so this is a perfectly “safe” strategy from the institutional sense.
What is fascinating is that it’s entirely possible for under-capitalised individuals to play these games. Most traders will lose money. But a few smart and lucky traders will reach the holy grail of a relatively safe, market-neutral, market-plus return.