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Mutual funds invest in futures and options, among other securities like shares, bonds, money market securities, or a combination of these. The scheme objective determines this portfolio. While some are interested in growth, some aim for income and others for stability.
This blog describes the manner in which mutual funds utilise derivatives, the reasons behind their use, the regulations involved and what investors ought to learn before making a conclusion related to the risk or gains.
Key Takeaways
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Mutual funds use derivatives mainly for hedging and portfolio balance, not speculation.
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SEBI caps total exposure and permits covered calls only on held index stocks.
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Arbitrage and equity savings funds use F&O to manage volatility.
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Derivatives can reduce risk but may limit upside returns.
Guidelines Around the Use of Futures and Options
Mutual funds are allowed to use derivatives for the purposes of hedging and portfolio balancing. Per SEBI regulations, the cumulative gross exposure (equity + debt + derivatives) must not exceed 100% of the net assets of the scheme.
Key Fund Categories:
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If you are looking for risk-free hedging options aimed at consistent returns, the Arbitrage Funds category will suit your needs.
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Another category, Equity Savings Schemes, partly hedges equity positions, leaves the rest unhedged, and invests the remainder in debt.
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In both categories, upside returns will be lower than pure equity funds as the hedging restricts full participation in market rallies.
Do Mutual Funds Invest in Derivatives (F&O)?
Yes, mutual funds invest in Derivatives, and under regulatory provisions, but seldom on a speculative basis, but as a hedging and portfolio management tool. Money can hedge the downside on their stakes in stocks by investing in futures or options.
For instance, when a fund is holding big-cap stocks, and there is a short-term volatility that is anticipated, it can hedge itself using index futures. This minimises exposure without the sale of the underlying stocks. Nevertheless, the use of derivatives is limited and controlled. Mutual funds are not considered similar to retail F&O traders. Their exposure to derivatives should be in accordance with the scheme goals and regulations imposed by SEBI.
Role of Futures and Options in a Mutual Fund
Derivatives tend to be used in a futures and options mutual fund strategy as risk-management instruments. Index Futures allow fund managers to hedge against market downturns as they maintain the long-term equity holdings. Options will assist in ensuring profits.
An example of this is the covered call strategy, which enables a fund to earn a premium on the stocks already owned. This is capable of bringing in additional income in lateral markets. Some types, like an arbitrage fund, involve the concomitant cash and futures positions to seize the differences in pricing. The equity savings funds are a combination of equity, debt and derivatives to deal with volatility. The goal is a balance of the portfolio and not aggressive speculation.
Regulatory Guidelines Around Futures and Options in a Fund
SEBI permits funds to use derivatives primarily for hedging purposes. Specifically, the fund can hedge its equity investments using index or stock derivatives. Recently, SEBI enhanced these measures to allow funds to write call option contracts under certain strict conditions. A call option is an agreement where the buyer has the right to purchase the underlying asset at a future date at a pre-decided price, while the seller is obligated to sell.
Until recently, mutual funds were allowed only to take long positions in derivative contracts, but they can now write (sell) option contracts. However, this is only allowed under the Covered Call strategy and is restricted to liquid Nifty 50 and Sensex Index constituents. This means they cannot write options without being long on the underlying shares, and the total exposure is capped at 15% of the scheme’s equity AUM.
Read More: What Is Covered Call?
Common Misconceptions About Mutual Funds and F&O
Several investors think that a futures and options mutual fund will aggressively invest in derivatives like a retail trader. This is not accurate. Derivatives are structured tools that are applied by mutual funds within the regulatory limits. They do not make leveraged bets without being exposed to them. Their derivative activity is reported through portfolio statements and scheme objectives. The second myth is that the use of derivatives does not at all reduce risk. In most instances reduces volatility by hedging. The investors should pay attention to the use of derivatives in the fund instead of responding to the existence of the F&O exposure in isolation.
Conclusion
To conclude, mutual funds are a great way of diversifying one's portfolio and offer professional management, tax efficiency, and several other advantages. SEBI regulates mutual funds to safeguard retail investors and has established a framework to utilise futures and options (derivatives) for hedging and yield enhancement. The regulator has ensured that writing derivatives is only allowed for index constituents where the fund has a corresponding long position. Some categories, such as Arbitrage and Equity Savings funds, are a great way to benefit from the low-risk nature of these futures and options strategies.
