The perfect hedge

SPECIAL REPORT

Sebi's recent circular allowing mutual funds to tap the derivatives market points to some exciting options. But will fund managers exercise it?

Sebi's new circular on how mutual funds can use derivatives markets gives the industry a much greater degree of freedom. Fund houses would not only be able to enhance the risk-return profiles of existing schemes, but also offer investors new products which were not possible earlier.

Till recently, fund managers were allowed to use derivatives only for hedging and for rebalancing portfolios. But mutual funds largely chose to stay away from derivatives. Why? Simple. Hedging involves a cost, which funds could ill afford given the competition in the industry.

Returns of all equity funds are now closely tracked not only in comparison to a benchmark index, but also against the performance of peer group funds.

If, for instance, an equity fund manager had hedged against market risk by going short on the index futures market, the returns on his portfolio would lag that of his peers by a significant margin, considering that the market has been headed upwards for over two years now. The losses on the short index futures position would wipe out much of the gains made by the underlying equity portfolio.

Sure, such a strategy would help at times when the markets are declining. But then, as some fund managers point out, the purpose of an equity fund is to give unit holders an exposure to the equity markets, along with the risks that entail such investments.

Since the investment objective of equity funds is to deliver high returns, by participating in a market that's risky, it would be out of character for a fund manager to have a hedged portfolio on a continual basis as that would take away not only the risk, but also the possibility of higher return.

Nevertheless, a handful of fund houses launched arbitrage funds to take advantage of price aberrations in the cash and futures markets. Since the strategy here was simply to buy stocks in the cash market and sell them in the futures market, positions were perfectly hedged and hence allowed under Sebi regulations.

There was only one problem; Sebi rules stipulated that the maximum derivatives position a fund could take was 50 per cent of its asset size. Thus, although the arbitrage activity generated good returns, overall returns were lower at 7-8 per cent (annualised) because only 50 per cent of the funds could be deployed in arbitrage, while the rest were in money market instruments.

What's new ?
Now there is no restriction on the amount arbitrage funds can invest in derivatives. They can engage in arbitrage activity up to 75-80 per cent of the asset size (the balance would be required for margins and liquidity purposes). This will obviously allow funds to exploit the mispricing opportunities in the market to the fullest.

Of course, it's not only arbitrage funds that will benefit from the new circular. Existing funds can now even take leveraged positions by buying derivatives products. Consider a fund that has 90 per cent of its Rs 1000 crore portfolio invested in equities.

If the fund manager is of the view that the markets are in for sharp upward movement, he can buy index futures (within the prescribed position limit for the fund) and take an exposure to the equity markets that is even higher than the fund's portfolio size of Rs 1000 crore. While this increases the risk of the portfolio, it also enhances the return profile of the fund.

Similarly, funds can take an additional exposure in stocks (for which derivatives trading is available) by buying stock futures. Funds can now also go short on either stocks or on the market, using the derivatives market. Thus, fund managers can not only place bets on stocks they think would be the top gainers, but also on those which could be the top losers.

Other strategies which can now be adopted include long hedges, where fund managers can first buy stock/index futures, and then gradually go about picking up stocks in the cash market.

The question is will the Rs 60,000 crore equity fund industry now use the derivatives markets even more, with much of the restrictions having gone. It's likely that most of the existing equity funds would continue to take it slow as far as the use of derivatives goes.

While hedging continues to be a 'no' with most fund managers, it's expected that funds' existing risk management framework, or for that matter guidelines from trustees of asset management companies, wouldn't leave much room for fund managers to experiment with derivatives, because of the bad experiences that have risen world-wide from leveraged positions.

HSBC's management globally views derivatives rather cautiously, for instance. The chief business development officer of its Indian arm, Asutosh Bishnoi, points out that they would use derivatives only if there is a definite, secure advantage for its investors.

That's not to say that the participation of existing funds will not increase. It's just that it may not increase substantially.

At the same time, however, the new rules do throw up exciting opportunities for new fund launches. To start with, one can expect more arbitrage funds, since fund managers can now engage in arbitrage activity upto 80 per cent of the total asset size.

Further, there could be funds that take alternative views. For instance, there could be arbitrage funds that are long stocks, and short a market index. This is not a perfectly hedged position, unlike current arbitrage funds which are perfectly hedged since they are long stocks and short futures on the same set of stocks.

But this would provide investors a different risk-return profile. There could also be structured products using options. One that adopts a strategy of buying options, for instance, would provide high upside potential, but at the same time limit downside to the extent of premium paid to buy the options.

Functions and limits
Also, while the removal of most restrictions on mutual funds throws open a number of vistas, the position limit of Rs 50 crore on stock derivatives do pose some limits on the use of derivatives by mutual funds.

The problem is that the Rs 50 crore limit applies across schemes for the whole fund house. This would pose a problem especially for funds that have an arbitrage fund which has already taken up much of the position limit.

This could pose a restriction (depending on the extent of exposure through the arbitrage fund) on how fund managers of other schemes within the fund house could use derivatives on the same stock. While this could hinder mutual fund participation to some extent, much depends on how involved fund houses want to get into the derivatives market. The ball, truly, is now in the court of the mutual fund industry.