evolutionofindiahedgefundstrategies-frombetatoal

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Evolution of India hedge fund strategies from beta to alphaThe case for quantitative strategies in the Indian markets

By: Ravi K. Jain, Savitar Capital LLC

Abst ractThis paper makes the case for the evolution of pure alpha strategies in India. Quantitativelydriven, 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.

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Indian market reformsIn the last decade, with the objectives of improving market efficiency, enhancingtransparency, preventing unfair trade practices and bringing the Indian market up tointernational 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 onexchanges side by side and a variety of derivatives are traded. The trading cycleshortened 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 forthe 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 stockmarkets are amongst the best in the world in terms of modernization and technology.

Leading this charge is Indias main securities regulatory body SEBI (Securities andExchange Board of India). In instituting the reforms, SEBI has taken the approach of atotal overhaul by throwing out decades old traditions and practices that existed in DalalStreet. 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 regulatorssuch as the SEC. In doing so and by leveraging Indias technology boom, they institutedreforms that catapulted Indias market structure from an old, inefficient one to one that ismodern, efficient, highly regulated and bereft of many of the legacy issues that still existeven 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 rapidlydeveloping 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 andcurrency futures. In that short time the NSE has become the largest single stockfutures exchange in the world and the 3 rd largest overall exchange in the world.


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Table 1 below shows some of the significant element of the securities market structureand their change from 1992 to 2003

Table 1: Changes in Indian Securiti es Market from 1992 and 2003

Features 1992 2003

RegulatorNo specific Regulator, butCentral Government oversight

A specialized Regulator for securities market (SEBI) vested with

powers to protect investors' interest and to develop and regulatesecurities market.

IntermediariesOnly Some of the Intermediaries(stock brokers, authorizedclerks etc.) regulated

A variety of specialized intermediaries emerged. They are allregistered and regulated. They, as well as their employees, arerequired to follow a code of conduct and are subject to a number of compliances.

Pricing of securities Determined by CentralGovernmentDetermined by market, either by the issuer through fixed price or bythe investors through book building.

Access toInternational Market No access

Companies allowed to issue ADRs/GDRs and raise ECBs. FIIsallowed trade in Indian Market. MFs also allowed to invest overseas.

Corporate Compliance Very little emphasis Emphasis on disclosures, accounting standards and corporategovernance.

Mutual Funds Restricted to public sector open to private sector and emergence of variety of funds and schemes

Trading Mechanism

Open outcry, Available at thetrading rings of the exchanges,Opaque, Auction/negotiateddeals.

Screen based trading system, Orders are matched on price-timeparity, Transparent, Trading P latform accessible all over the country.

Aggregation Orderflow

Fragmented market throughgeographical distance. Orderflow unobserved.

Order flow observed. The exchanges have open electronicconsolidated limit order books (OECLOB)

Anonymity in Trading Absent Complete

Settlement System Bilateral Clearing House of the Exchange or the Clearing Corporation is thecentral counter party

Settlement Cycle14 day account periodsettlement, but not adhered toalways

Rolling settlement on T+2 basis

Form of settlement Physical Mostly electronic

Basis of S ettlement Bilateral Netting Multi-lateral Netting

Transfer of SecuritiesCumbersome Transfer byendorsement of security andregistration by issuer

Securities are freely transferable. Transfers are recorded electronicallyin book entry form by depositories

Risk Management No focus on risk managementComprehensive risk management system encompassing capitaladequacy, limits on exposure and turnover, VaR based margining,client level gross margining, on line position monitoring etc.

Derivatives Trading Absent Exchange Traded futures and options


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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 fundsSince the turn of the century, there has been tremendous excitement globally about theIndia 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 BRICcountries . With its economic and market reforms, India encouraged and attracted hugeamounts of foreign investment. The GDP is growing at about 8% a year with growthcoming from the internal consumption market, infrastructure development and massivegrowth of exports of services and products. Thus the Indian markets enjoyed a hugebull run. Foreign money was flowing into India via hedge funds, PE funds, infrastructureand real estate investments.

Almost all the hedge funds investing in India were long only which is what investorswanted ride the bull! From 2003 to end of 2007 the Sensex index went from about3350 to 20,300 a dramatic 512% increase.

However in 2008 the global markets suffered a financial tsunami and the Indian marketswere not spared they dropped about 52% in 2008. For foreign investors this wascompounded by the Indian Rupee dropping over 22% as well. It is estimated thatamong 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 followsuit.

Suddenly the beta only strategy model unraveled leaving many investors hurting.Investors have lost confidence in the Indian markets and many analysts are predicting along time before the market can recover.


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Is hedging and shorting viable?History has shown that investors are always chasing returns, which explains theexuberance and attraction of the Indian beta only funds. However history also showsthat no bull run lasts forever and markets will tumble on occasion.

In 2007 and early 2008 many investors were getting concerned about India yet notmany Indian funds established hedges. Given the existence of a derivatives market, itwould 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 fundamentallong only investors that have little to no knowledge or expertise in hedging andquantitative strategies. They are absolute value investors and shorting to most of them issimply taking away returns, as opposed to creating relative value alpha returns. Sincederivatives and options are relatively new in India, many did not fully appreciate theseinstruments. Not long ago I met an established Indian fund manager who barely knewwhat a put option was. In addition there seems to be a general perception that shortingand 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 cashstocks (only recently has short selling been opened up on a limited basis), but theexistence of the single stock and index futures market allows for completely transparentshort selling. Many of these funds have not been accessing the futures and optionsmarkets as they were not registered as FIIs and were limited to P-notes issued bybanks, 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 tradedproducts, clearly makes viable the ability to hedge and go short, using both options andfutures. 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 indexfutures is very liquid accounting for about 32% of the volume. There are 255 singlestock futures out of over 1200 actual companies listed on the NSE. The averageturnover of all single stock futures is about $2.7b per day, however this tends to beconcentrated in the top 100 or so names, tapering off quickly thereafter. Index optionshave reasonable liquidity accounting for 37% of total market volume, while only very fewsingle stock options have any decent volume. The NSE is by far the largest single stockfutures 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, gosideways for a while or may even go into a bear market scenario it is really anyonesguess. In such an environment, beta-only strategies offer a very limited choice forinvestors. Soon there is going to be demand by investors for strategies that can delivermore - that can take advantage of the changing Indian landscape and derive returns inspite of the uncertainty i.e. demand for portable alpha strategies.


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In order to generate true alpha, quantitative strategies need to be evolved that aremarket neutral and can exploit a variety of inefficiencies in the market. This entails theactive use of short positions as well as derivatives.

In mature markets such as the US, quantitative strategies are typically based onanalyzing significant amount of historical data and the discovery of statisticalrelationships and signals that give a positive expected return with lower volatility. Thecreation of such strategies tends to be almost totally numbers driven, with little concernor worry about the fundamental characteristics of the individual components of thestrategy. Thus most quantitative strategies distance themselves from the constituentsand 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/futuresarbitrage; index versus stock basket arbitrage and pairs trading.

In most cases the portfolios in mature markets have many components e.g. a typicalquantitative strategy may have over 100 long names against 100 short names- and theuniverse they can select from is also large due to the number of listed stocks in thesemarkets. This creates automatic internal diversification and thus reduction of risk to anyindividual 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 generalb) Specific risk : which is risk/return specific to the stock

Beta strategies look at both at the nave level a broadly diversified beta portfolio (likebeing long the index) is just the systematic portion. Stock pickers add alpha to their betaby looking at the specific risk and determine which stocks have potential for higherreturns based on the combination of systematic and specific characteristics.

Quantitative strategies largely ignore the specific risk and are mainly focused onextracting returns from the noise in the systematic risk. As mentioned above, they canignore the specific risk due to internal diversification of the portfolios.

Indian markets, as we discussed, provide the ability to short using transparent singlestock futures. These have significant advantages over short cash stock as the borrowingrate is implied and transparent; there are lower margin requirements and transparencyallows the markets to continuously function without fear of short selling bans. Theavailability of a single stock futures market, in our opinion, is the single mostimportant reason that equity quantitative strategies are viable in the Indianmarket.

With the availability of many years of data as well as real time data - quantitativelong/short equity strategies are thus definitely possible in Indian markets. However asdiscussed above, quantitative strategies typically ignore the specific risk as individualspecific 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 thetotal risk of a portfolio will be much larger. Thus it is our opinion that the successfulapplication of quantitative strategies to the Indian market requires a fundamental overlaythat works in conjunction with the quantitative analysis in order to alleviate the above.


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Fundamental analysis overlay provides information and opinion on a stocks specific risk,which becomes an important input into the quantitative strategys portfolio creation andmanagement process.

Such a combination of skill sets both quantitative balanced with a qualitative overlay isnot easy to find and implement. Funds that desire to be successful in such strategiesneed to employ talent across the spectrum of quantitative to qualitative.

In Indian markets most quantitative strategies are low frequency strategies with slowerturnover and much higher returns per trade. This is largely due to the uneven trade flowsin India between retail and institutional flows and the fact that cash stocks are long onlywhile futures are long and short. These uneven flows create large deviations inobservable relationships between stocks and indices that tend to mean revert or returnto normal over the course of days or weeks. With few participants trading suchquantitative strategies, the deviations may persist for longer periods than in marketswhere traders quickly jump in to take advantage of the deviation. As these strategiesbecome more prevalent, the deviations will contract faster and the trades will becomehigher frequency.

Fundamental value based long/short strategies (such as the Fama-French value basedlong/short portfolio) have longer turnover times, similar to other markets. In Indianmarkets such portfolios can generate outsized returns as the markets are still veryfundamental value driven.

Options based strategiesOptions based strategies are still in their infancy. Most options trading occurs in indexoptions which are predominantly used for portfolio hedging purposes. Index optionshave averaged about $3.7b in trading value per day. Single stock options volumes arevery 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 currentlythere are limited opportunities in single stock options trading as volumes will onlysupport small amounts of investment.

The high liquidity in index options (both broad and sector indices) provides an excellentvehicle to hedge broad market or sector exposure from a portfolio, thus reducing betarisk. They also allow generation of returns from just options trading strategies likespread 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 optionsin India. Trading volumes will grow as both retail and institutional investors expand theirparticipation in this market. The options market will present many quantitative trading

opportunities such as conversions, spread trades, dispersion, volatility arbitrage etc. Inaddition, as spreads are still wide, providing liquidity in options market making will be anexciting source of low volatility returns, especially with the introduction of direct marketaccess as described below.

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


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technologically advanced and efficient electronic trading infrastructure. It is expected thatin the next several years there will be a high adoption of DMA in the industry and thus asignificant growth of trade flow over DMA.

DMA in markets in the US and Europe has provided the buy side with greater controlover trades, faster and better quality execution, facilitation of complex trading strategiesand lower brokerage fees. In the US, about 18% of total flows are via DMA. Earlyresponse from market participants in India have suggested that there will be similaracceptance of DMA in India.

The introduction of DMA allows for efficient algorithmic quantitative trading. Thus lowfrequency quantitative trades can be automated and trading strategies developed thatwill constantly poll the market data for trading opportunities and automatically placemarket orders. This will result in high frequency quantitative and statistical arbitragestrategies 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 werethe 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 toapply for DMA access was Renaissance Technologies the leader in algorithmic trading clearly showing the recognition of the potential this has to generate serious alphareturns in India.

Summary and conclusionIt is now time for the next generation of hedge fund strategies in India those based ongenerating portable alpha by applying long/short, market neutral and arbitragestrategies. The mature and advanced Indian market structure with the availability of asingle 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 becomehigher frequency. The introduction of DMA will enable high frequency, algorithmicstrategies 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 expectenough liquidity to generate significant alpha returns from strategies such as volatilityarbitrage and dispersion trading and options market making.

Once again the open, transparent, well regulated and technologically advanced marketstructure in India is the main driver behind this creating a conducive environment forthe 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 inderivatives trading, quantitative strategies and risk management. Recently he has expanded thisinterest to the Indian markets and is in the process of launching a market neutral, pure alphaIndia fund. He can be reached at [email protected]
mailto:[email protected]:[email protected]

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