As markets wobble and future prospects look uncertain, several funds are adopting futures and options to deliver returns. IIFL Capital Enhancer Fund is the latest to new fund offer (NFO) to adopt this strategy. There were two NFOs recently following this strategy – DSP BlackRock ACE Fund Series 2 and Kotak India Growth Fund Series IV
IIFL Capital Enhancer Fund is an ‘interval fund’ meaning that entry and exit will be allowed into the fund only in specific ‘window’ periods. These window periods will be 365 days apart. In other words, investing in say, April 2018 means that you have to wait till April 2019 to exit. A window will open in April 2019 for you to exit. If you miss the transaction window (called Specified Transaction Period or STP), you have to wait for another year. The use of this ‘interval’ structure allows the fund to dispense with exit loads.
The fund will invest predominantly in large-cap stocks forming part of the Nifty 50. Within this space, it will focus on IT, energy and financial stocks. The fund’s equity exposure will range from 65-100% of its assets, with the rest in debt. However, the fund will hedge its equity exposure by buying put options.
A put is a right (but not an obligation) to sell a stock or index at a particular price and to protect the buyer from market declines. In return, the buyer pays a premium.
Here’s an example. Assume the fund buys a Nifty 10,000 puts. These will begin earning money as soon as the Nifty falls below 10,000. In return, the fund pays a ‘premium’, a fixed sum of money, rather like the premium you pay on an insurance policy.
Exactly how much of the fund’s money will be devoted to buying puts, depends on the fund manager. However, the premium on the put options cannot exceed 8% of the net assets of the fund. In addition, the amount of exposure ‘hedged’ using these puts is capped at 110% of the net assets of the fund. In other words, the fund can only use puts to protect its downside. It cannot use puts to make outright profits from a fall in the market.
When will a hedged strategy outperform?
The premium for a put costs money and will reduce the returns of the fund to some extent. If the market does not decline below the put levels then the premium would be in effect ‘wasted.’
What if the market declines and then goes up? Well, in this case also the premium has been in effect ‘wasted.’ The fund outperformed while the market was down but you couldn’t take your money off the table because you were locked-in anyway. You can in theory sell units of the fund on the stock market but the stock market liquidity for mutual fund units tend to be very low.
What if the market declines and stays low? In this case, the fund’s puts will mitigate the loss and will do better than a standard large-cap equity fund.
Here’s an illustration (figures are hypothetical, not actual):
Nifty Level at Inception
Scenario at the time of your exit
Market declines to 9000 and then recovers to 11,000
Premium Wasted: The fund would have looked good during the fall but this has been wiped out by the time of your exit.
Market declines to 9000 and ends at 9000
Outperformance: Fund loses money on its equity holdings. However, it makes up some or all of this loss through its put options.
Market goes straight up from 10,600 and ends at 14,000
Premium Wasted: The fund makes money from the gain in the market but it has in effect ‘wasted’ the premium money on its puts.
Upcoming elections in India, rate hikes in the US and corporate governance issues have brought the market’s five-year bull phase into question. A hedged strategy deftly managed might well outperform a ‘no frills’ equity mutual fund. However, this fund can at best be an ancillary/alternative investment.