Finding Alphas, 2nd Edition

28Finding an Index Alpha

By Glenn DeSouza

Alpha discovery is not limited to single-company equity instruments. With the dramatic rise of passive investing in the past two decades, exchange-traded funds (ETFs) and related index products have fostered the growth of various index-based alpha strategies. Historically based in large investment banks because of their reliance on technology investment, balance sheet usage, and cheap funding, these strategies have become more popular among buy-side firms in recent years, including large quant- and arbitrage-focused hedge funds and market-making firms.

INDEX ARBITRAGE IN PRACTICE

Index arbitrage is an alpha strategy that attempts to profit from differences between the actual and theoretical futures prices of a stock index, adjusted for the trader's unique costs, including cost of capital and borrowing costs (or stock rebate). The theoretical value, or the fair value in industry parlance, of an index futures contract can be described by the following top-down adjustment formula:

Holding a futures contract instead of directly investing in the underlying companies of a stock index frees up additional capital for investment (because futures have a much lower margin requirement than stock investments, particularly in the US), but it forces contract holders to forgo dividends, thus making interest rates and dividends the two primary differences ...