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Tata Equity Management Fund offers to mitigate risk by using derivatives which limit both the upside and the downside.

After the success of Reliance Equity Fund, which mopped up a record-breaking Rs 5,750 crore, Tata Mutual Fund has come up with a similar fund "� Tata Equity Management Fund (TEMF).

Structured as an 18-month closed-ended fund, its primary investment objective is to generate capital appreciation and provide long-term growth opportunities by investing in equities and equity-related instruments.

The fund will also use the derivatives route to protect the portfolio from downside risk while aiming to maximise long-term returns.

"In the current market situation, investors are confused as to what they should do. With such a product, investors can earn good returns and, at the same time, can get protection from the downside risk," says Sandeep Sharma, head-private banking, SG Private Banking.

Embedded with a proactive derivative management feature, the fund hopes to identify some potential value-creation opportunities in case market has sharp up or down movements.

"On the one hand, the economic fundamentals look good from a long-term view, given a high GDP growth, higher level of expenditure into infrastructure, increased global business for the BPO sector and new opportunities in pharmaceutical and IT industries. However, in the recent bullish market, relative valuations have gone up significantly and investors are now worried about the optimisation of returns while investing. The new fund presents a strategy to minimise risk and maximise returns in such a potentially volatile market," says Ved Prakash Chaturvedi, managing director, Tata Mutual Fund.

TEMF seeks to invest across market capitalisations in a diversified portfolio of carefully selected stocks. It would also capitalise on both short-term and long-term opportunities through a stock-specific or index-oriented shorting strategy to enhance returns.

If the fund manager has a strong conviction that a stock or a group of stocks is overvalued, he can short-sell without owning the shares. This creates an opportunity for the fund to potentially benefit even when the stock price undergoes downside volatility.

Such a strategy can work well in a volatile market. Says Abhay Aima, head of private banking, HDFC Bank, "In a volatile market, such a long-short fund is better positioned."

He, however, cautions: "If the market keeps moving in one direction, such a fund will not perform well."

Sameer Kamdar, national head-mutual funds, Mata Securities India Pvt Ltd, echoes the same view: "This fund has an in-built risk hedging mechanism to minimise the downside risk. Such a fund will be advantageous in a volatile market, as it is witnessed these days."

The disadvantage of such a fund is that "on the upside, it may not be able to deliver returns at par with the diversified equity funds that are unhedged".

How exactly does the fund work? The fund's derivative strategy will depend on the fund manager's perception of the markets and also based on the month-end weighted average P/E multiple of the S&P CNX Nifty. 
 

HEDGING STRATEGY
Weighted average PE Ratio of S&P CNX Nifty	Maximum portfolio hedge as a % of equity portfolio
Up to 14	10 to 20
14-18	20 to 25
18-22	25 to 50
22-26	50 to 70
26-30	70 to 90
Above 30	90 to 100

The P/E multiple is normally an indicator of how expensive and risky the market or an individual stock is. When P/E begins to rise or when the market risk goes up, the fund manager will increase his exposure to derivatives to limit the downside risk.

If some stocks in the index look overvalued, the fund manager can also take short positions in such stocks, even if they do not figure in the fund's portfolio already.

During a bearish phase, the fund manager can decrease his percentage of exposure in derivatives, to increase the net exposure to fundamentally good stocks available at relatively attractive valuations.

On the other hand, when P/E falls or when the market risk comes down, the fund manager will reduce his exposure to derivatives to catch the upside potential.

When other existing funds can also invest in derivatives, why launch such a fund? Says Kamdar, "That other funds have an option means it depends on the fund manager whether to invest in derivatives or not. But in Tata Equity, there is a mandate to invest some portion in derivatives depending upon the P/E of S&P CNX Nifty. So, the portfolio is compulsorily hedged."

Adds Sharma: "In case of Tata Equity the investment in derivatives is more disciplined compared with other existing funds."

Other equity funds also hedge their portfolio, but this fund, like Reliance Equity Fund, specifies the quantity it will hedge based on pre-defined criteria. The downside of this is that if the S&P CNX Nifty P/E multiple is above 30, then the fund manager hedges 90-100 per cent of the equity portfolio.

In such a scenario, the return that the fund delivers decreases radically. A 100 per cent hedged portfolio will not deliver any return "� positive or negative.

In short, funds using derivatives as strategy to mitigate volatility may be a good idea, but this obviously comes with a downside "� that you may not always be able to capture the full upside.

TEMF is initially an 18-month close-ended equity scheme with a weekly exit option (by paying an exit charge) to investors during the close-ended period. Exit charge would depend upon the total span of the investment, and this rate would narrow down with the passing of each week.

Upon completion of 18 months, the scheme will automatically be converted into an open-ended scheme. During the NFO period, there is neither entry nor exit load.

The NFO is open from May 15 to June 9.