Mutual Funds & Hedging....
The fierce swings that the capital markets have witnessed during the past few months have compelled the mutual fund industry to introduce ‘risk-proof’ investment strategies for you. Hedging has become the name of the game…
Recently, the Sensex has been on a rollercoaster ride and it has become difficult to gauge whether it will rise considerably or free-fall between one day and the next. Evidentially speaking, it fell from 14,700 points on February 9 to 12,400 on March 5, shedding 2,400 points in a matter of less than 30 days. And it’s not just the direct investors who pay through their noses amidst such outbreaks. Even those who have opted for mutual funds, in order to avoid exposure to market volatility, have begun to feel the pinch. The best of fund managers, who possess all the specialized skills required to make your investments grow, become helpless when markets shed 678 points in a day, as witnessed on February 28. A similar setback of 471 points was faced on March 5 as well. The Net Asset Value (NAV) of your unit holdings in such cases are bound to crash, at times, even below the face value. Welcome to ‘Hedging’ Hedging is an investment strategy that is used to minimize the risk that your portfolio faces due to severe price movements in the equity market. It tries to lock in your existing profits or invest in instruments whose prices move inversely to that of your stocks, so as to protect your capital from stock market volatility and subsequent erosion. This risk management technique uses instruments from the equity derivatives segment, namely the Futures and Options (F&O) market and other debt and money market instruments, such as government bonds and securities that fetch you a fixed rate of return. Investment pattern of risk management funds Although the exact strategy deployed depends upon the nature of the risk management fund and on how it allocates your money across instruments, generally, anything between 65 and 100 per cent is invested in equities--including the segments of margin, delivery, and F&Os. And the remaining corpus (if any), is put into debt and money market instruments. Broadly, decisions of which segment to invest in are governed entirely by market conditions and aim more to protect the invested capital than achieving maximum possible returns by taking on higher risks. This is why the returns on such funds are sometimes lower than other top-performing equity-oriented schemes. However, in general, such funds aim for good returns and use F&O to lock in the returns. Besides, in falling markets, these funds perform better than plain vanilla diversified equity funds. Working of hedge funds Let us understand the functioning of such funds with an example. Suppose the markets go bullish. In this case, the fund may invest a portion of its corpus; say 50 per cent, in the cash equity segment, and the rest in ‘call’ options in the F&O segment. In the case of ‘call’ options, the fund has to merely deposit a comparatively small amount, called the premium, in order to avail of the benefit of purchasing shares at a predetermined price on a particular date in the future, even if the market price goes beyond this predetermined price. There is, however, no obligation to purchase the shares at the predetermined price if the market price is lower. With this strategy, larger quantities of shares can be picked up at relatively lower costs resulting in greater chances of profits, while the risk exposure remains limited to the option premium. For example, let’s say the share price of XYZ Limited is currently Rs 200 and the fund expects it to rise beyond Rs 210. It will purchase a ‘call’ option with a strike price of Rs 210. If the share price hits Rs 210 before the contract expires, the fund will exercise the call and gain to the extent of the difference between the market price and the strike price. But in case the stock price falls, the fund will ignore the contract and lose only the premium paid to purchase the call. Similarly, ‘put’ options are used when the markets are expected to decline. With a view to bring risk to minimum possible levels, fund managers simultaneously use both, call and put options, thereby hedging the portfolio. Big players foraying in Owing to its strategic nature, retail investors are always cautioned to avoid trying hands-on hedging. Besides, selection of the right kind of hedge fund plays a crucial role in the future of your investments. According to a recent Morgan Stanley report, out of the total of 8,500 hedge funds operating worldwide, it is only the top 200 hedge funds that control 90 per cent of total assets under management. Meanwhile in India, fund houses like UTI, Reliance, Kotak and DBS Chola have launched various capital protection schemes and hedged equity funds under different names, guaranteeing that the value of your initial investment will never go below the ascertained level, irrespective of where the markets are headed. - Hedge funds offering guaranteed preservation of your initial investment, irrespective of market movements, are suitable for investors who are unwilling to take on unlimited risks involved in regular equity oriented funds.- Hedge funds make use of a combination of equity and debt instruments, including stocks, futures and options on stocks and indices, money market and debt instruments and are thus in a better position to balance risks in equity market investing.- Fund houses like UTI, Reliance, Kotak and DBS Chola already offer such schemes, while others are following suit.
Recently, the Sensex has been on a rollercoaster ride and it has become difficult to gauge whether it will rise considerably or free-fall between one day and the next. Evidentially speaking, it fell from 14,700 points on February 9 to 12,400 on March 5, shedding 2,400 points in a matter of less than 30 days. And it’s not just the direct investors who pay through their noses amidst such outbreaks. Even those who have opted for mutual funds, in order to avoid exposure to market volatility, have begun to feel the pinch. The best of fund managers, who possess all the specialized skills required to make your investments grow, become helpless when markets shed 678 points in a day, as witnessed on February 28. A similar setback of 471 points was faced on March 5 as well. The Net Asset Value (NAV) of your unit holdings in such cases are bound to crash, at times, even below the face value. Welcome to ‘Hedging’ Hedging is an investment strategy that is used to minimize the risk that your portfolio faces due to severe price movements in the equity market. It tries to lock in your existing profits or invest in instruments whose prices move inversely to that of your stocks, so as to protect your capital from stock market volatility and subsequent erosion. This risk management technique uses instruments from the equity derivatives segment, namely the Futures and Options (F&O) market and other debt and money market instruments, such as government bonds and securities that fetch you a fixed rate of return. Investment pattern of risk management funds Although the exact strategy deployed depends upon the nature of the risk management fund and on how it allocates your money across instruments, generally, anything between 65 and 100 per cent is invested in equities--including the segments of margin, delivery, and F&Os. And the remaining corpus (if any), is put into debt and money market instruments. Broadly, decisions of which segment to invest in are governed entirely by market conditions and aim more to protect the invested capital than achieving maximum possible returns by taking on higher risks. This is why the returns on such funds are sometimes lower than other top-performing equity-oriented schemes. However, in general, such funds aim for good returns and use F&O to lock in the returns. Besides, in falling markets, these funds perform better than plain vanilla diversified equity funds. Working of hedge funds Let us understand the functioning of such funds with an example. Suppose the markets go bullish. In this case, the fund may invest a portion of its corpus; say 50 per cent, in the cash equity segment, and the rest in ‘call’ options in the F&O segment. In the case of ‘call’ options, the fund has to merely deposit a comparatively small amount, called the premium, in order to avail of the benefit of purchasing shares at a predetermined price on a particular date in the future, even if the market price goes beyond this predetermined price. There is, however, no obligation to purchase the shares at the predetermined price if the market price is lower. With this strategy, larger quantities of shares can be picked up at relatively lower costs resulting in greater chances of profits, while the risk exposure remains limited to the option premium. For example, let’s say the share price of XYZ Limited is currently Rs 200 and the fund expects it to rise beyond Rs 210. It will purchase a ‘call’ option with a strike price of Rs 210. If the share price hits Rs 210 before the contract expires, the fund will exercise the call and gain to the extent of the difference between the market price and the strike price. But in case the stock price falls, the fund will ignore the contract and lose only the premium paid to purchase the call. Similarly, ‘put’ options are used when the markets are expected to decline. With a view to bring risk to minimum possible levels, fund managers simultaneously use both, call and put options, thereby hedging the portfolio. Big players foraying in Owing to its strategic nature, retail investors are always cautioned to avoid trying hands-on hedging. Besides, selection of the right kind of hedge fund plays a crucial role in the future of your investments. According to a recent Morgan Stanley report, out of the total of 8,500 hedge funds operating worldwide, it is only the top 200 hedge funds that control 90 per cent of total assets under management. Meanwhile in India, fund houses like UTI, Reliance, Kotak and DBS Chola have launched various capital protection schemes and hedged equity funds under different names, guaranteeing that the value of your initial investment will never go below the ascertained level, irrespective of where the markets are headed. - Hedge funds offering guaranteed preservation of your initial investment, irrespective of market movements, are suitable for investors who are unwilling to take on unlimited risks involved in regular equity oriented funds.- Hedge funds make use of a combination of equity and debt instruments, including stocks, futures and options on stocks and indices, money market and debt instruments and are thus in a better position to balance risks in equity market investing.- Fund houses like UTI, Reliance, Kotak and DBS Chola already offer such schemes, while others are following suit.
Source: TimesMoney (dated March13,2007)
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