Evolution of India hedge fund strategies from beta to alpha

The case for quantitative strategies in the Indian markets By: Ravi K. Jain, Savitar Capital LLC Abstract This paper makes the case for the evolution of pure alpha strategies in India. Quantitatively driven, market neutral and derivative strategies have the ability to generate significant returns. The main facilitator is the strong, advanced market structure and regulatory environment in India. Introduction of DMA and the growing options markets further this argument. * * * *

Indian market reforms In the last decade, with the objectives of improving market efficiency, enhancing transparency, preventing unfair trade practices and bringing the Indian market up to international standards, a package of reforms consisting of measures to liberalize, regulate and develop the securities market have been introduced in India. All kinds of securities debt and equity, government and corporate are traded on exchanges side by side and a variety of derivatives are traded. The trading cycle shortened and trades are settled T+2. Transaction costs have dropped to about 5% of where they were 15 yrs ago. As a result of these reforms, the market design and structure has changed drastically for the better, so much so that in 2006 the NSE was awarded the Derivative Exchange of the year by Asia Risk. The use of technology has also been a key driver, such that now the Indian stock markets are amongst the best in the world in terms of modernization and technology. Leading this charge is Indias main securities regulatory body SEBI (Securities and Exchange Board of India). In instituting the reforms, SEBI has taken the approach of a total overhaul by throwing out decades old traditions and practices that existed in Dalal Street. They looked around the globe and understood best practices and the evolution of developed markets. They communicated, sought advice and shared information actively with other regulators such as the SEC. In doing so and by leveraging Indias technology boom, they instituted reforms that catapulted Indias market structure from an old, inefficient one to one that is modern, efficient, highly regulated and bereft of many of the legacy issues that still exist even in developed markets like the US. They had the luxury of leapfrogging over the painful development process of the maturing of a market and went straight to rapidly developing a mature, technology enabled advanced market. This is exemplified by the last 7 years in which the Indian markets have introduced WAP, Index and single stock options, single stock futures, IR futures, a VIX contract and currency futures. In that short time the NSE has become the largest single stock futures exchange in the world and the 3rd largest overall exchange in the world.

Table 1 below shows some of the significant element of the securities market structure and their change from 1992 to 2003
Table 1: Changes in Indian Securities Market from 1992 and 2003 Features Regulator 1992 No specific Regulator, but Central Government oversight 2003 A specialized Regulator for securities market (SEBI) vested with powers to protect investors' interest and to develop and regulate securities market.

Intermediaries

A variety of specialized intermediaries emerged. They are all Only Some of the Intermediaries registered and regulated. They, as well as their employees, are (stock brokers, authorized required to follow a code of conduct and are subject to a number of clerks etc.) regulated compliances. Determined by Central Government No access Determined by market, either by the issuer through fixed price or by the investors through book building. Companies allowed to issue ADRs/GDRs and raise ECBs. FIIs allowed trade in Indian Market. MFs also allowed to invest overseas. Emphasis on disclosures, accounting standards and corporate governance. open to private sector and emergence of variety of funds and schemes

Pricing of securities Access to International Market

Corporate Compliance Very little emphasis Mutual Funds Restricted to public sector Open outcry, Available at the trading rings of the exchanges, Opaque, Auction/negotiated deals. Fragmented market through geographical distance. Order flow unobserved. Absent Bilateral 14 day account period settlement, but not adhered to always Physical Bilateral Netting Cumbersome Transfer by endorsement of security and registration by issuer

Trading Mechanism

Screen based trading system, Orders are matched on price-time parity, Transparent, Trading Platform accessible all over the country.

Aggregation Order flow Anonymity in Trading Settlement System

Order flow observed. The exchanges have open electronic consolidated limit order books (OECLOB) Complete Clearing House of the Exchange or the Clearing Corporation is the central counter party Rolling settlement on T+2 basis Mostly electronic Multi-lateral Netting Securities are freely transferable. Transfers are recorded electronically in book entry form by depositories Comprehensive risk management system encompassing capital adequacy, limits on exposure and turnover, VaR based margining, client level gross margining, on line position monitoring etc. Exchange Traded futures and options

Settlement Cycle Form of settlement Basis of Settlement Transfer of Securities

Risk Management

No focus on risk management

Derivatives Trading

Absent

Table 2 below shows the growth of the entire Indian market structure since 1998.
Table 2 Indian Stock Markets: Growth of Market Structure (In Number)

Source : SEBI

Indian markets and long only funds Since the turn of the century, there has been tremendous excitement globally about the India Inc story. This is a story of the emergence of the next great economic super power along with China, Russia and Brazil prompting coining of the term BRIC countries . With its economic and market reforms, India encouraged and attracted huge amounts of foreign investment. The GDP is growing at about 8% a year with growth coming from the internal consumption market, infrastructure development and massive growth of exports of services and products. Thus the Indian markets enjoyed a huge bull run. Foreign money was flowing into India via hedge funds, PE funds, infrastructure and real estate investments. Almost all the hedge funds investing in India were long only which is what investors wanted ride the bull! From 2003 to end of 2007 the Sensex index went from about 3350 to 20,300 a dramatic 512% increase. However in 2008 the global markets suffered a financial tsunami and the Indian markets were not spared they dropped about 52% in 2008. For foreign investors this was compounded by the Indian Rupee dropping over 22% as well. It is estimated that among the 70 or so hedge funds aimed at India, there has been a total drop in assets of over two thirds in 2008. Many have shut down and many others are expected to follow suit. Suddenly the beta only strategy model unraveled leaving many investors hurting. Investors have lost confidence in the Indian markets and many analysts are predicting a long time before the market can recover.

Is hedging and shorting viable? History has shown that investors are always chasing returns, which explains the exuberance and attraction of the Indian beta only funds. However history also shows that no bull run lasts forever and markets will tumble on occasion. In 2007 and early 2008 many investors were getting concerned about India yet not many Indian funds established hedges. Given the existence of a derivatives market, it would not be unreasonable to expect some degree of hedging by such funds. The reason partly lies in that the vast majority of Indian fund managers are fundamental long only investors that have little to no knowledge or expertise in hedging and quantitative strategies. They are absolute value investors and shorting to most of them is simply taking away returns, as opposed to creating relative value alpha returns. Since derivatives and options are relatively new in India, many did not fully appreciate these instruments. Not long ago I met an established Indian fund manager who barely knew what a put option was. In addition there seems to be a general perception that shorting and hedging is really not possible in India as an Indian fund manager recently stated. This perception is far from reality. Of course, shorting has not been possible on cash stocks (only recently has short selling been opened up on a limited basis), but the existence of the single stock and index futures market allows for completely transparent short selling. Many of these funds have not been accessing the futures and options markets as they were not registered as FIIs and were limited to P-notes issued by banks, thus creating a perception that hedging using shorting was too difficult. Thus the reality is that the Indian market structure, with its breadth of exchange traded products, clearly makes viable the ability to hedge and go short, using both options and futures. It is up to the fund manager to ensure access to this market and use it wisely. However the question of liquidity does remain. The average daily trading value of the futures/options market has been about $10b in the last 2 years. The market in index futures is very liquid accounting for about 32% of the volume. There are 255 single stock futures out of over 1200 actual companies listed on the NSE. The average turnover of all single stock futures is about $2.7b per day, however this tends to be concentrated in the top 100 or so names, tapering off quickly thereafter. Index options have reasonable liquidity accounting for 37% of total market volume, while only very few single stock options have any decent volume. The NSE is by far the largest single stock futures exchange in the world. Liquidity has been growing in the last 2 years alone, the number of listed single stock futures has grown from about 160 to 255.

Generating alpha from market neutral strategies in India It is clear that the India straight-up bull run is over. The markets may recover, go sideways for a while or may even go into a bear market scenario it is really anyones guess. In such an environment, beta-only strategies offer a very limited choice for investors. Soon there is going to be demand by investors for strategies that can deliver more - that can take advantage of the changing Indian landscape and derive returns in spite of the uncertainty i.e. demand for portable alpha strategies.

In order to generate true alpha, quantitative strategies need to be evolved that are market neutral and can exploit a variety of inefficiencies in the market. This entails the active use of short positions as well as derivatives. In mature markets such as the US, quantitative strategies are typically based on analyzing significant amount of historical data and the discovery of statistical relationships and signals that give a positive expected return with lower volatility. The creation of such strategies tends to be almost totally numbers driven, with little concern or worry about the fundamental characteristics of the individual components of the strategy. Thus most quantitative strategies distance themselves from the constituents and simply treat them as a set of numbers. Examples of such strategies include long/short portfolios based on sectors, skewness of returns, earnings revisions, fundamental value measures, volatility etc.; cash/futures arbitrage; index versus stock basket arbitrage and pairs trading. In most cases the portfolios in mature markets have many components e.g. a typical quantitative strategy may have over 100 long names against 100 short names- and the universe they can select from is also large due to the number of listed stocks in these markets. This creates automatic internal diversification and thus reduction of risk to any individual stock, providing the ability to not have to focus on any particular stock. A simple way to look at this is to consider the return as composed of a) Systematic risk: which is risk/return from the market in general b) Specific risk: which is risk/return specific to the stock Beta strategies look at both at the nave level a broadly diversified beta portfolio (like being long the index) is just the systematic portion. Stock pickers add alpha to their beta by looking at the specific risk and determine which stocks have potential for higher returns based on the combination of systematic and specific characteristics. Quantitative strategies largely ignore the specific risk and are mainly focused on extracting returns from the noise in the systematic risk. As mentioned above, they can ignore the specific risk due to internal diversification of the portfolios. Indian markets, as we discussed, provide the ability to short using transparent single stock futures. These have significant advantages over short cash stock as the borrowing rate is implied and transparent; there are lower margin requirements and transparency allows the markets to continuously function without fear of short selling bans. The availability of a single stock futures market, in our opinion, is the single most important reason that equity quantitative strategies are viable in the Indian market. With the availability of many years of data as well as real time data - quantitative long/short equity strategies are thus definitely possible in Indian markets. However as discussed above, quantitative strategies typically ignore the specific risk as individual specific risk is small on the overall return if the portfolio is large and diversified. In India, since the universe of stocks is still relatively small, the contribution of specific risk to the total risk of a portfolio will be much larger. Thus it is our opinion that the successful application of quantitative strategies to the Indian market requires a fundamental overlay that works in conjunction with the quantitative analysis in order to alleviate the above.

Fundamental analysis overlay provides information and opinion on a stocks specific risk, which becomes an important input into the quantitative strategys portfolio creation and management process. Such a combination of skill sets both quantitative balanced with a qualitative overlay is not easy to find and implement. Funds that desire to be successful in such strategies need to employ talent across the spectrum of quantitative to qualitative. In Indian markets most quantitative strategies are low frequency strategies with slower turnover and much higher returns per trade. This is largely due to the uneven trade flows in India between retail and institutional flows and the fact that cash stocks are long only while futures are long and short. These uneven flows create large deviations in observable relationships between stocks and indices that tend to mean revert or return to normal over the course of days or weeks. With few participants trading such quantitative strategies, the deviations may persist for longer periods than in markets where traders quickly jump in to take advantage of the deviation. As these strategies become more prevalent, the deviations will contract faster and the trades will become higher frequency. Fundamental value based long/short strategies (such as the Fama-French value based long/short portfolio) have longer turnover times, similar to other markets. In Indian markets such portfolios can generate outsized returns as the markets are still very fundamental value driven.

Options based strategies Options based strategies are still in their infancy. Most options trading occurs in index options which are predominantly used for portfolio hedging purposes. Index options have averaged about $3.7b in trading value per day. Single stock options volumes are very low, accounting for only about 2% of the total daily volume in the F/O market, which is only about $200m most of which is concentrated in very new names. Thus currently there are limited opportunities in single stock options trading as volumes will only support small amounts of investment. The high liquidity in index options (both broad and sector indices) provides an excellent vehicle to hedge broad market or sector exposure from a portfolio, thus reducing beta risk. They also allow generation of returns from just options trading strategies like spread trades, sector dispersion trading, index options versus basket of stocks etc. Over the next several years, we should see an increased interest in single stock options in India. Trading volumes will grow as both retail and institutional investors expand their participation in this market. The options market will present many quantitative trading opportunities such as conversions, spread trades, dispersion, volatility arbitrage etc. In addition, as spreads are still wide, providing liquidity in options market making will be an exciting source of low volatility returns, especially with the introduction of direct market access as described below.

The future impact of DMA In late 2008, India announced direct market access (DMA) to the equity exchanges. The introduction of DMA for institutional investors reflects the countrys move towards a

technologically advanced and efficient electronic trading infrastructure. It is expected that in the next several years there will be a high adoption of DMA in the industry and thus a significant growth of trade flow over DMA. DMA in markets in the US and Europe has provided the buy side with greater control over trades, faster and better quality execution, facilitation of complex trading strategies and lower brokerage fees. In the US, about 18% of total flows are via DMA. Early response from market participants in India have suggested that there will be similar acceptance of DMA in India. The introduction of DMA allows for efficient algorithmic quantitative trading. Thus low frequency quantitative trades can be automated and trading strategies developed that will constantly poll the market data for trading opportunities and automatically place market orders. This will result in high frequency quantitative and statistical arbitrage strategies which are a huge source of portable alpha returns. Even in the mess of 2008, the only strategies in the developed markets that provided positive returns were the high frequency, algorithmic trading strategies. DMA in allows for the deployment of such strategies in India. When DMA was first announced, one of the first companies to apply for DMA access was Renaissance Technologies the leader in algorithmic trading clearly showing the recognition of the potential this has to generate serious alpha returns in India.

Summary and conclusion It is now time for the next generation of hedge fund strategies in India those based on generating portable alpha by applying long/short, market neutral and arbitrage strategies. The mature and advanced Indian market structure with the availability of a single stock futures market allows for such strategies to be implemented. Currently most of the strategies will be low frequency, but have the potential to generate outsized, non-correlated returns. Over the next several quarters these will become higher frequency. The introduction of DMA will enable high frequency, algorithmic strategies in the next several years, offering a new source of alpha returns. The options market is nascent but growing. Over the next several years we expect enough liquidity to generate significant alpha returns from strategies such as volatility arbitrage and dispersion trading and options market making. Once again the open, transparent, well regulated and technologically advanced market structure in India is the main driver behind this creating a conducive environment for the evolution of hedge fund strategies from beta to alpha.

Ravi K. Jain, is the founder of Savitar Capital, LLC. He has over twenty years of experience in derivatives trading, quantitative strategies and risk management. Recently he has expanded this interest to the Indian markets and is in the process of launching a market neutral, pure alpha India fund. He can be reached at ravi@savitarcapital.com