Mutual Funds and Derivatives

Role of Derivatives in Mutual Funds

Introduction

Derivatives have become a much discussed topic among the investment community. Today more and more investors are curious to learn about it. This word often conjures up visions of speculative dealings, a big boom and a big crash. Some people are also of the view that derivative trading is nothing but reckless speculation. But this notion is not true. If used carefully, a derivative transaction helps to cover risks, which would arise on the trading of securities on which the derivative is based.

In simple terms, derivatives can be defined as financial instruments whose value is derived from the value of underlying assets. These underlying assets can be equities, commodities, currencies and bonds. Derivatives trading commenced in India in June 2000, after SEBI granted the final approval to this effect in May 2001. Since then it has outperformed cash market by leaps and bounds. SEBI permitted the derivative segments of two stock exchanges, National Stock Exchange (NSE) and Mumbai Stock Exchange (BSE) and their clearing houses to commence trading and settlement in approved derivatives contracts. In the beginning, SEBI permitted trading in index futures contracts based on S&P CNX NIFTY and BSE SENSEX indices. This was followed by approval for trading in options based on these two indices and options on individual securities and single stock futures in 2001. Trading and settlement in derivative contracts is done in accordance with the rules, byelaws and regulations of the respective exchanges and their clearing corporations.

The derivatives market is very useful as it performs a number of economic functions like:

They help in transferring risks from risk averse investors who are not willing to bear it to those who are willing and able to bear it.
They help in the discovery of future as well as current prices.
They help to increase savings and investment in the long run.
They help in increasing the total traded volumes because of participation of more and more investors in the market.
They catalyze entrepreneurial activity.

During the last two years, a lot has been said and heard about the use of derivatives by mutual funds. Before going into details one should have clear understanding about the term mutual fund. There are many retail investors who are not able to invest directly in the stock markets due lack of knowledge about the capital markets or due to lack of sufficient time to track market behavior in order to take informed investment decisions. Mutual funds industry has emerged as one of the best investment channel for such people because they are very cost efficient and it is very easy to invest in them. A mutual fund is simply a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. The mutual fund has a professional fund manager who is responsible for investing the pooled money into the securities market. These managers have been around the industry for a long time and have the academic credentials to back it up. The biggest advantage of mutual funds is diversification. Diversification is the idea of spreading out money across many different types of investments. When one investment is down another might be up. Diversification reduces risk tremendously. There are different kinds of mutual funds to cater to varied investment objectives such as - Growth Funds, Income Funds, Balanced Funds, and Liquid Assets Funds, also known as Money Market Funds.

Derivative investment brings many benefits to the fund manager’s portfolio. They serve as one of the best tool for hedging. Other than hedging, one of its special aspects is the high leverage they can contribute. This means fund managers have the ability to obtain exposure to a relatively large asset amount for a small initial outlay. The result it brings is a high-risk and high-reward investment. A number of New Fund Offers (NFOs), which propose to invest in derivatives, have caught the attention of investors. DSP Merill Lynch Equity, Kotak 30, Kotak MNC, Prudential ICICI Infrastructure, Reliance Growth Fund, Reliance Regular Saving Fund are some schemes which have invested in derivatives segment. Derivatives are skilled tools and require expertise on the part of fund managers. Techniques like hedging reverse arbitrage, covered call writing give a support as well as value to the funds during troubled times. Although, derivatives trading in India has been in existence for more than seven years, their use by mutual funds is relatively new.

Previously, mutual funds were allowed to use derivatives only for hedging purposes and for rebalancing their portfolios. But after the recommendations of the Secondary Market Advisory Committee, in September 2005, market regulator, SEBI (Securities and Exchange Board of India) allowed Mutual Funds to participate in the derivatives market, bringing them at par with Foreign Institutional Investors (FIIs), with respect to position limits in index futures, index options, stock options and stock futures contracts.

SEBI Guidelines for Mutual Funds Investment in Derivative Segment

As per the new guidelines released by SEBI, Mutual Funds would be treated at par with a registered FII in respect of position limits in index futures, index options, stock futures and stock options. Further the mutual funds will be considered as trading members like registered FIIs and the schemes of Mutual Funds would be treated as clients like sub-accounts of FIIs.

Applicability to New Schemes and Existing Schemes

In its circular, SEBI instructed that all new funds opting to participate in the derivatives market must make appropriate disclosures in the fund offer document regarding the extend and manner of its participation in derivatives and the risk factors associated with it to be explained with suitable examples.

The participation of existing schemes of Mutual Funds in derivatives was also allowed subject to the following constraints:

The extent and the manner of the participation in the derivatives market to be disclosed and communicated to the unit holders.
The risk associated with the participation in the derivatives market to be disclosed and explained with appropriate examples.
Consent of a majority of the unit holders to be obtained towards the proposed participation.
An exit option to be provided to dissenting unit holders. This option should be valid of a period of one month before the mutual fund commences trading in the derivative segment.
No exit load to be charged to unit holder deciding to exercise the above option.

Position Limits

Position limits in index option contracts for a particular underlying index has been fixed to Rs. 250 crores or 15% of the total open interest of the market in index options on the corresponding index, whichever is higher, per stock exchange. Similarly position limit in index futures contract on a particular underlying index has been fixed to Rs. 250 crores or 15% of the total open interest of the market in index futures on the corresponding index, whichever is higher, per stock exchange.

Further to the above constraints, a mutual fund’s short position in index derivatives (short futures, short calls and long puts) must not exceed (in notional value) the mutual fund’s holding of stocks. Moreover, its long positions in index derivatives (long futures, long calls and short puts) must not exceed (in notional value) the Mutual Fund’s holding of cash, government securities, T-Bills and similar instruments.

The Mutual Fund position limits in a derivative contract on a particular underlying stock i.e. stock option contracts and stock futures contract, have been modified as follows:

For stocks in which market wide position limit is less than or equal to Rs. 250 crore, the mutual fund position limit would be 20% of the market wide position limit
For stocks in which market wide position limit is greater than Rs. 250 crore, the mutual fund position limit would be Rs. 50 crore.

This amendment in the regulation has cleared the path for mutual funds to use derivatives in their portfolio more efficiently.

Derivatives like futures and options are now used by Mutual Funds for hedging their portfolio to manage risks, for speculation to clock profits and for arbitrage to earn risk free profits.

The various trading strategies employed by the Mutual Funds in the derivatives segment are described in the subsequent sections.

Hedging

The only thing that is certain about stock markets is the uncertainty. We have witnessed volatility at its best during the past few months. Such volatility has affected Mutual Funds and other investors alike.

It is well known that hedging is the prime reason which led to emergence of derivatives. These financial instruments allow its users to undertake activities at a substantially lower risk therefore mutual funds employ derivatives for hedging, which could be more appropriately understood as a portfolio management strategy assigned to minimize exposure to an unwanted risk, while still allowing the business to profit from the investment. Every portfolio has a market linked risk associated with it. As a result, the portfolio reacts to market volatility. To insulate the fund from the same, the fund manager can hedge his portfolio by taking an opposite position in the futures market. E.g. if the fund manager foresees a downturn in the stocks held in his portfolio, he can hedge the same by selling (stock/index futures) in the derivatives segment.

Hedging should not be considered as a vehicle for making money. The best it can achieve is minimizing the risk. Also the hedged position would make lower profit as compared to the unhedged position. Alternatively there might even be instances where the hedged position incurs a loss, but this loss would be much lower than what an unhedged portfolio would have incurred.

Speculation

Speculation is a trading strategy in which a position is taken on the future movement in the prices of the share. Previously mutual funds were not allowed to speculate in the derivatives market because of the risks involved in them. They were allowed to use derivatives only for the purpose of hedging and for rebalancing their portfolios. But with the amendment in the regulation by SEBI, Mutual Funds could also use the opportunity of speculating in derivatives market.

A fund manager may have a view that markets are going to rise and that he can benefit by taking a position on the index. Based on his view, he can buy NIFTY futures and hold on to that position until the price rises to his expectations. If the fund manager’s view about the price movement proves to be correct (i.e. the market rises), the fund will make a profit on its NIFTY futures position. On the contrary, if his view proves incorrect then the fund will end up making losses. Conversely, if a fund manager is bearish about the market, he will sell NIFTY futures and will hold on to it, until the price declined. Similarly, the fund manager can also speculate in individual stocks by buying or selling stock futures/options.

Speculation in derivatives market is like a double edged weapon, i.e. there exists a possibility of making profits or incurring losses based on how the fund manager perceives the market movement. Futures and Options are similar instruments for speculation. However there is an important difference between the two, i.e. when a speculator uses futures, the potential losses as well as the potential gain is very large, while when options are used no matter how bad things get, the speculator’s loss is limited to the amount of premium paid.

Arbitrage

Arbitrage is the third strategy, which involves locking in a riskless profit by simultaneously entering into purchase and sale transactions of equivalent or identical instruments in two or more markets in order to benefit from the price difference. Arbitrageurs thrive on market imperfections. This strategy normally acts as a shield against market volatility as the buying and selling transactions offset each other. Some mutual funds like UTI mutual fund and JM mutual fund have launched arbitrage funds, which employ the arbitrage strategy of buying in cash and simultaneously selling in futures market.

In an arbitrage transaction, returns are calculated as the difference between the futures price and the cash price at the time of the transaction. Ideally the positions are held till the expiry of the futures contract when the offsetting positions cancel each other and initial price difference is realized. This arbitrage strategy makes the fund immune to market volatility i.e. the fund will not be affected by market fluctuations. There are huge arbitrage opportunities in the cash and futures market. Many fund managers actually prefer to use reverse arbitrage to gain from the difference in prices of cash and futures markets.

Conclusion

Having permitted the Mutual Funds to trade in derivatives segment, SEBI has opened the gates for small and retail investors to benefit from indirect investments through Mutual Funds with much lesser investment than otherwise in the form of margin money required in direct derivatives segment. Moreover since the portfolio is managed by qualified professionals, these small investors need not worry about the complex trading strategies involved in derivatives trading, while still gaining from the fund manager’s expertise. On the other hand, this amendment has also infused greater liquidity into the market.