Mastering Derivatives: Using index futures to adjust portfolio beta bl-premium-article-image

Venkatesh Bangaruswamy Updated - June 24, 2023 at 09:28 AM.

Previously in this column, we discussed when to choose futures over options for short-term trading. This week, we discuss how portfolio managers can use futures to adjust their portfolio’s beta.

Equitising cash

Suppose you manage investments and have a long position in stocks. You believe that the market is likely to continue its uptrend in the short term. You could buy shares with the cash you hold in the portfolio. But picking stocks to capture the upside potential in the market exposes the portfolio to high risk. How?

It is possible that the Nifty Index can go up even when heavy weights such as ITC or Reliance Industries trade flat or marginally decline. What if you buy stocks that eventually decline even as the index moves up? Not only will your portfolio fail to capture the upside, but it could suffer losses. An optimal strategy would be to go long on index futures.

The process is simple: You must identify the index whose returns closely aligns with your portfolio returns. If your holding is in large-cap stocks, then your appropriate benchmark is the Nifty Index. Next, use the futures contract on the appropriate benchmark. You should go long on this futures contract to gain from your positive view on the index in the short term.

You could use a simple equation to determine the number of contracts to go long. Suppose the current beta of the portfolio is 1.05 and you want to increase the beta to 1.25. Therefore, the portfolio must be adjusted by the increase in beta of 0.20 times the portfolio value. Dividing this product by Nifty futures contract value will give the number of contracts to go long. The above calculation assumes index futures contract moves one-to-one with its underlying index. If not, you must adjust the futures contract value by its beta. This process of using cash in the portfolio to buy index futures to gain market exposure is called equitising cash.

You may rightly wonder as to how this is different from going long on index futures when you believe the index is likely to move up. Equitising cash is a strategy a portfolio manager implements to align the portfolio to a benchmark index, especially when the benchmark is expected to move up. That is the reason you must consider the target beta of the portfolio when you are setting up the futures position.

Tax implications
Short-term capital gains tax on equity is lower than the tax on derivatives
Optional reading

Equitising cash has less slippage costs; if you were to buy individual stocks, prices of some stocks could move up before you can complete the transaction. Also, because you pay only initial margin, futures contract allows you to take equivalent spot positions with lower initial capital. Note the tax incidence if you implement this strategy in your personal capacity: Short-term capital gains tax on equity is lower than the tax on derivatives; the latter is considered non-speculative business income and taxed at your marginal tax rate.

The author offers training programmes for individuals to manage their personal investments

Published on June 24, 2023 03:58

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