Expert explains method for long-term investing in Nifty through combo of ETFs, Futures & Puts

Investing in the Index is better than investing in individual stocks

CA Govind Jhawar, a noted expert with FinIdeas, has pointed out that the dynamic nature in which the Index (Nifty) is managed by weeding out the non-performing stocks and ushering in good stocks, makes it the ideal investment vehicle for investors.

He has explained that investing in the Nifty protects investors from Inflation Risk, Default Risk, Exchange Rate Risk, Liquidity Risk, Business Risk and Unsystematic Risk.

In fact, the Nifty has risen from 890 on 1st Jan 1999 to the present 18000, delivering a cumulative return of 1922%, which works out to a CAGR of 14.65%.



Better to invest partly in Futures instead of buying an ETF

Govind Jhawar has advised that instead of investing 100% of our funds in an Index ETF or Mutual Fund, it is advisable that we invest only 30% of our funds in the ETF and buy futures equivalent to the balance 70%.

The advantage of this is that while we get the benefit of 100% of the investment, we are required to pay only the margin money for the 70%, leaving us with huge cash at our disposal.

This remaining cash can be invested in secure assets like the RBI Bonds at an interest rate of 7.15%.

This will partly cover the cost of financing (~5%) incurred to buy the futures and also the cost of the hedging.

Buy Puts to cover the downside risk. It costs about 5% but offers valuable protection

He has also advised that we should buy Puts equivalent to the value of the portfolio to protect ourselves from a downside risk such as that caused by the Corona crisis when the markets went into a melt down.

Better to buy a synthetic future

One of the problems of buying a Future is that we have to pay the MTM loss in cash to the broker. However, if we instead buy a synthetic future (i.e. buy an ATM Call and sell an ATM Put), we are spared of this requirement while having the same risk reward as in the regular Future.

In 20 years, the Nifty has given a CAGR of 14.54% while this strategy has given a CAGR return of 17.89%

According to data, an investment of Rs 1 crore in the Nifty on 31.12.2002 would have yielded a gain of Rs 14.77 crore as of 31.12.2021, amounting to a CAGR return of 14.54%. However, the same amount invested through the strategy of ETF, Futures and Puts would have yielded a gain of Rs 25.90 crore, amounting to a CAGR of 17.89.

We can see the benefit of hedging in the 2008 sub-prime crisis. While the Nifty lost a colossal 52%, the strategy was untouched with a minor loss of only 3%.

The Slides used in the presentation can be viewed here.

Execution problems

One of the obvious problems of the strategy is its execution. Futures are available only for three months and have to be renewed periodically. Also, buying LEAPS Calls and Puts has the problem of low liquidity and mismatched pricing on Ask and Bid spreads.