How Mutual Funds Use Derivatives & Benefits From It

Derivatives have become a much-discussed topic in the investment community and investors are curious to learn more about it.

Simply put, derivatives are financial instruments whose value is derived from the value of underlying assets. These underlying assets can be equities, commodities, currency, and bonds among others. Derivatives like futures & options are used by mutual funds for hedging their portfolio to manage the risk, for speculation to clock profits and for arbitrage to earn risk-free profits.

Although, derivatives trading in India has been in existence for more than five years, their use by mutual funds is of a relatively recent origin. Previously mutual funds could use derivatives only for hedging purposes; also, they could deploy no more than 50% of their assets towards hedging.

Now as per new guidelines released by Sebi (Securities and Exchange Board of India), mutual funds can increase their net assets exposure up to 80% in the futures and options segment. This amendment in the regulation has cleared the path for mutual funds to use derivatives in their portfolio more effectively.

In this article, we discuss the various strategies that mutual funds can utilize and how they stand to benefit from the same.

Hedging

The only thing that is certain about stock markets is the uncertainty. In recent months, we have witnessed volatility at its best. This has impacted mutual funds and other investors alike. In such a scenario, the two most likely alternatives for mutual funds are:

Sell the stocks immediately (i.e. distress selling). If the stocks have been purchased at higher prices, such an action could prove to be detrimental for the fund and its investors.

Remain invested and continue to bear the brunt of volatility. This could lead to interim losses (although notional) till the stock market recovers. But with derivatives, there is a third and smarter alternative:

Over shorter time frames, index futures can be used to reduce or eliminate stock market fluctuations.

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 a contrary position in the futures market.

For example, 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 will typically make lower profit than the unhedged position. Alternatively there might even be instances where the hedged position incurs a loss, but this loss will be much lower than what an unhedged portfolio would have incurred.

Speculation

Speculation is a strategy in which a position is taken on the future movement in the prices of the shares. Previously mutual funds were not permitted to speculate in the derivatives market. They were allowed to use derivatives only for the purpose of hedging. But with the recent amendment in the regulations by Sebi, mutual funds can also use the opportunity of speculating in derivatives.

A fund manger 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 expected level. If the fund manager's view about the market proves to be correct (i.e. the market rises), the fund will make a profit on its Nifty future position.

On the contrary, if his view proves incorrect then the fund will end up making a loss. Conversely, if a fund manager feels bearish about the market, he will sell Nifty futures and will hold on to it until the markets moved southwards. Similarly, the fund manager can also speculate in individual stocks by buying or selling stock futures/options.

Speculation in derivatives is a double-edged sword, i.e. there exists a possibility of making profits or incurring losses based on how the fund manager's call pans out. Speculation can be done on both futures and options (Call & Put).

Though futures have potentially unlimited upside and downside, the payoff for options is a bit unique. For the buyer of the option, the loss is limited to the premium whereas for the seller it is unlimited.

Arbitrage

Arbitrage is a strategy, which involves simultaneous purchase and sale of identical or equivalent instruments in two or more markets in order to benefit from a discrepancy in pricing. This strategy normally acts as a shield against market volatility as the buying and selling transactions offset each other.

In an arbitrage transaction, returns are calculated as the difference between the futures price and 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. Since the portfolio of arbitrage funds is completely hedged at all times to lower the risk of loss/erosion of gains, it also in turn caps the returns that the fund could have clocked if the portfolio was unhedged i.e. these funds have a limited upside.

Despite the fact that arbitrage funds offer investors the opportunity to benefit from investments in equities by making use of derivatives, the fund cannot be compared to conventional diversified equity funds, especially on the returns parameter.

The returns from arbitrage funds would typically be much lower than those of equity funds. While hedging and arbitrage strategies, when used effectively, can make the fund's portfolio immune to market volatility, using derivatives for speculation holds the possibility of converting the fund into a typical high risk -- high return investment proposition.