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FUND TREND

Fund managers are loath to hedge their portfolio for fear of being laggards. The irony: they underperform miserably.

Since the market mayhem started on May 11, nearly 85 per cent of equity funds have underperformed the key indices. This is despite the fact that funds are now free to use derivatives to completely hedge their portfolio and even short sell to profit from any decline in the stock prices.

After the Sebi allowed funds to short sell, two mutual funds "� Reliance Mutual and Tata Mutual "� even launched schemes, with much fanfare, which have a stated strategy of using derivatives to benefit from both upmove and downtrend in the market.

Most other funds are allowed to use derivatives implicitly to protect their portfolio values from crashing in the event of a market meltdown like the one we have seen since May 11. But none of this seems to have helped arrest the erosion in fund net asset values (NAV).

It is not that fund managers did not quite anticipate a correction. Most market participants were crying hoarse that stocks were getting into overvalued zone and a correction was long overdue before the recent fall, making a clear case for hedging.

Still, if fund managers did not aggressively use derivatives to protect their portfolio it was because they were hesitant to hedge for fear of underperforming the indices and peers in case the markets continued their frenzied bull run.

"The reality is that existing equity funds are competing to perform, and most of them want to deliver good returns. Funds do not hedge much as it will lower the returns," says Ved Prakash Chaturvedi, managing director, Tata Mutual Fund.

There are others who feel that they are looking to maximise returns over the long term, and using derivative simply adds more to short-term costs than long-term returns.

Says Anand Shah, vice-president, equity funds, Kotak Asset Management, "We continue to remain long on India, so there is no need to hedge much."

Seconds Tridib Pathak, chief investment officer, DBS Chola Mutual Fund, "Using derivatives involves taking a very short-term view on the market and it also involves an implied cost. Taking a very short-term view implies that you have to sacrifice some of your gains."

Surely there is merit, at least theoretically, in using short selling and derivative products.

Says Chaturvedi, "The benefit of short selling is that when stocks are over-priced, it helps create value but it has to be used cautiously. Normally, you make money by buying stocks, but at very high P/E multiples, you can make money by shorting stocks."

Shah offers another perspective: "In typical long-short funds like these, at every point of time you have both long and short positions, which is not the case in other equity funds."

He adds, "In such funds, when the market goes down you end up losing less than the market and when the market goes up you gain less than the market."

Defending the launch of Tata Equity Management Fund, Chaturvedi says, "Such a scheme is beneficial in volatile markets. We expected volatility and, hence, we launched such a product."

The reality, however, is that the performance of these funds has not been inspiring. Their returns have been pretty much in line with the rest of the plain vanilla equity funds. Reliance Equity Fund has delivered negative returns of 15.65 per cent in the last one month.

Similarly, for instance, DBS Chola Contra Fund (which does not use derivatives) has fallen 22.7 per cent since May 11, while Reliance Equity Fund (which uses derivatives) has declined 19.6 per cent. Though exact numbers are not available, the higher cash component in Reliance Equity has helped the fund fall marginally lesser than its peers, say fund analysts. 
 

SOME SCHEMES THAT USE DERIVATIVES...
	1 Month Returns (%)
Reliance Equity Fund	-19.60
Kotak 30 Fund	-25.90
Prudential ICICI Discovery Fund	-29.90
Prudential ICICI Fusion Fund	-27.80
Sensex	-24.90
SOME SCHEMES THAT DO NOT USE DERIVATIVES...
DBS Chola Contra Fund	-22.70
Principal Equity Fund	-26.20
ABN Amro Equity Fund	-29.50
Sensex	-24.90
* Returns are calculated from May 10, '06 to Jun 12, '06

Pathak says, "We feel disciplined stock selection is the best hedge, as using derivatives does not help much."

If not as a consistent strategy, some fund managers do use derivatives as a one-off strategy to benefit from specific market situations.

For instance, some fund managers have been benefiting by exploiting the arbitrage opportunity between cash and futures. Especially in the recent market volatility, both index and several stock futures have been trading at steep discount to their underlying cash price.

Says Shah, "At times when futures trade at a discount to cash market, we buy futures and sell stock, trying to benefit from the reverse arbitrage."

Between the two "� futures and options "� fund managers prefer futures. Says Chaturvedi, "The option of using options is illiquid as compared to futures. Futures are a simple product to trade and understand than options and, hence, it is more liquid. Also, it provides you the opportunity to enter and exit at lower impact cost."

Shah adds, "For futures, STT (securities transaction tax), brokerage cost and impact cost are less. Impact cost is low because futures are more liquid."

Shah says he has been using options too. "Around two to three years back, when the disinvestment case related to oil-marketing companies was going on, we had these stocks in our portfolio, so we bought put options on these stocks to protect from the downside. Thus, we benefited using derivatives," he says.

"The benefit of option is that it is like an insurance product. You participate on the upside, but on the downside you do not lose more than the premium. You have an option of not exercising the contract on the exercise date," Shah adds.

For now, however, it appears that fund managers are not fully confident of using derivatives as a mechanism to protect capital. Investors will, thus, have to continue to bear the brunt of volatile markets.

The brighter side, however, is that "with short selling being allowed the industry has got an opportunity to create a lot of structured products," says Shah.