The outsized returns from NSE’s Alpha index ( Mint Article )

The best way to generate alpha, it appears, is to buy the stocks that have generated the highest alpha in the immediate past. In November 2012, the National Stock Exchange of India Ltd (NSE) had launched the CNX Alpha index, which measures the performance of stocks with the highest alpha from within a set of top 300 stocks. The index has since risen at a compounded annual average growth rate (CAGR) of 35.3%. In comparison, the CNX Nifty index has risen at a CAGR of 20.3%. 

As the chart shows, the index’s performance is impressive from a long-term perspective as well. Alpha is essentially the excess return made by a stock/portfolio vis-a-vis a benchmark index, but after adjusting for the higher risk associated with the investment vis-a-vis the benchmark. If a fund manager or an investor is making higher returns, compared with the benchmark index on a risk-adjusted basis, he/she is said to be generating alpha. Needless to say, this requires good stock picking skills. 

Data for the CNX Alpha index, however, suggests that in the long run, even following a passive strategy can result in alpha. All one needs to do is buy the stocks in the CNX Alpha index, or stocks that have generated the highest alpha in the preceding 12 months. The index is revised every quarter, which ensures laggards are dropped and the stocks with the highest alpha are used to calculate the index. Stocks with the highest alpha get the highest weight in the index, in proportion to their risk-adjusted excess returns vis-a-vis the same metric for the entire portfolio of 50 stocks. 

It must be noted here that while the Alpha index does well in bullish markets, it understandably does terribly when there are corrections. In the correction between January 2008 and March 2009, when the Nifty fell 59.1%, the Alpha index fell as much as 78.7%. But in the bull market before that, its returns were far higher; and in the five-year period till March 2009, the Alpha index trumped the Nifty by a fair margin. The chart also shows the new index has taken sprightly steps in the past year, with news of the change in government lifting the hopes of investors. Investors with a relatively lower stomach for risk can mimic the CNX Low Volatility index, which has also done far better than the Nifty over the long run and in the past year, without the wild swings of the Alpha index. 

And at the other end of the spectrum, those with a stomach for risk and trying to capitalize on short-term swings in the market, the CNX High Beta index has provided outsized returns during some rallies. For instance, in the rally immediately after the election results in 2004 and 2014, and in early 2009 rally, the stocks in the high beta index expectedly rose much faster than any of the other indices. Since NSE doesn’t yet have derivatives products on any of these indices, the only way to mimic their returns is to buy the underlying stocks, the list of which is available on the exchange’s website. Unfortunately, though, it looks like NSE doesn’t publish the individual weights of the stocks in the index.