Derivatives, we are often warned, should be off bounds for lay investors, given the complexities involved and the losses likely to be incurred when they take exposures without adequate understanding.

But for mutual fund managers, these derivatives become great tools to achieve multiple purposes. Market regulator SEBI allows mutual funds to use derivatives for hedging and arbitrage strategies.

Cash-futures arbitrage and covered call options are two common strategies adopted by fund managers to achieve low-risk hedging of the portfolio, enable receipt of accruals in the form of defined gains via premiums and to ensure equity taxation to investors.

While three hybrid categories — equity savings, arbitrage and balanced advantage — use derivatives extensively in their portfolios, others in the large, mid and small-cap equity categories too use such tools.

Here, we explain why funds use these tools, the details of the derivative strategies and the tax benefits available to investors.

Why the usage?

As such, the basic premise in the case of hybrid fund categories using derivatives is that returns must be better than debt schemes’, but would be lower than from equity categories.

The case for hedging using derivatives is quite simple. There are several stocks in the portfolio that could be cyclical and may also involve volatile moves. Simple cash market exposure alone could result in a bit more risk, affecting the portfolio.

Therefore, arbitrage and covered call strategies (explained in detail later) are used to hedge a portion of the portfolio. This is done even by diversified equity funds at times.

Even when benchmarks run up sharply resulting in concerns over expensive index levels or if there are heavy inflows into the fund that are not deployable immediately, a proxy exposure to the market via derivatives is possible.

However, in the case of hybrid equity funds, derivatives end up being useful at another level. The derivative strategies here are used for accrual purposes, especially in the equity savings and arbitrage categories.

By taking a low-risk arbitrage position or writing a covered call option, fund managers ensure that there are regular payouts from the hedged position. This payout serves to bolster overall returns for these hybrid funds, in addition to hedging the portfolio.

In the case of arbitrage funds, the entire equity exposure is fully hedged. This is north of 70 per cent in most cases. Debt instruments help give additional returns.

Given that equity derivatives also qualify as equities, taxation is favourable (discussed in the last part of article).

How derivative strategies work

There are predominantly two strategies that mutual funds use with derivatives. These are the cash-futures arbitrage and writing covered call options. Here are illustrations of how the strategies generally work.

Cash-futures arbitrage

Almost all fund houses use this strategy for their arbitrage, balanced advantage (dynamic asset allocation) and equity savings funds. Some also use it in other diversified equity fund categories, although very selectively. The general basis for this strategy is to take advantage of the price difference of a share between the cash and futures markets. Usually, this is mostly applicable when the price of the share is higher in the futures market than in the cash market.

This strategy involves buying a share of a firm in the cash market. Simultaneously, the fund manager would also short (or sell) the stock of the same company in the futures market if it trades at a higher price than in the cash market.

For illustration, let’s say a stock trades at ₹100 in the cash market and₹105 in the futures market. The fund manager will buy in the cash market and sell in the futures market. During the expiry of the derivatives contract, three scenarios could emerge.

Stock remains at ₹100: If the stock remains at ₹100, then the fund manager will still make a profit of ₹5 per share on the trade. From the sale in the futures market, she would have generated ₹105, while the cash market price is at ₹100. So, the net gain would be (₹105-100) or ₹5.

Stock moves to ₹105: If the stock moves to ₹105, there would be no profit from the sale in the futures market (₹105-105). But the fund manager will still make ₹5 from the gains in the cash market (₹105-100).

Stock moves to ₹110: In case the stock moves to ₹110, there will be a ₹5 loss in the futures market (₹110-105). However, the fund manager will make a ₹10 gain in the cash market (₹110-100), resulting in a net gain of ₹5 per share.

Stock falls to ₹90: Let’s consider a scenario where the share price falls to ₹90 in the cash market. The loss in the cash market would be ₹10 (₹100-90). But the gains in the futures market would be ₹15 (₹105-90), resulting in a net gain of ₹5.

Thus, the fund manager makes a fixed gain of ₹5 in all scenarios (ignoring brokerage, STT and other costs) of the stock price’s movements. This ‘fixed’ gain acts as an accrual income to the portfolio, somewhat similar to interest payouts from bonds.

However, it is not always as straightforward as mentioned above as the premium at which futures trade will keep varying depending on the supply and demand of that contract. And constant monitoring is needed to achieve profits net of all costs.

Just as we saw the cash-futures arbitrage with stocks in the examples above, the strategy can be replicated with indices as well. Nifty and Bank Nifty are the most popular indices for derivative play.

So, fund managers would buy stocks in the Nifty and Bank Nifty in the same proportion as in the index in the cash market and short the indices in the futures market when there is an arbitrage opportunity.

The contract expiry is the last Thursday of the month. Cash and future market prices tend to converge by expiry date.

Covered call options strategy

In this strategy, the fund manager holds a long position or buys a stock and sells (writes) a call option on the underlying stock. In markets where the expectations are that there wouldn’t be too much volatility, this strategy may prove useful. A narrow market is ideal for executing this strategy.

For illustration purposes, let’s say the stock trades at ₹100 in the cash market and the call premium is ₹3 for a strike price of ₹107 after three months.

Price remains at ₹100 during expiry: If the price remains at ₹100, then the buyer will not exercise the call option. This is because it is out of the money – that is, the strike price is more than current market price. The fund manager pockets the ₹3 premium that was received while writing the call option.

Price rises to ₹107 during expiry: If the stock price increases to ₹107, the call option will expire worthless. The stock price, when at or below the strike price of the call option that was sold on expiry, will lead to the option value becoming zero. Thus, the seller gets the whole premium as profit. So, the fund manager will receive ₹7 on stock plus ₹3 on the premium, taking the total profit to ₹10.

In other words, selling call option will bring down the purchase price of the stock to the extent of the premium received. In our example, writing a call option for ₹3 will reduce the buying price of the underlying to ₹97 (purchase price of ₹100 minus premium received of ₹3). So, the gain can also be seen as the difference between the effective purchase of ₹97 and the stock price on expiry, which is ₹107. So, the net gain will be ₹10.

Price rises to ₹110 upon expiry: In case the price moves to ₹110, again, the call option will be exercised. The fund manager has to sell at ₹107 when the price is ₹110. So, there is a notional loss of ₹3. But given that she would also receive ₹3 for writing the call, the purchase price would come down by ₹3 i.e., to ₹97. So, the net gain would still be ₹10 (₹107-97).

If you notice, the maximum gain when the stock price goes beyond ₹107 will be capped at ₹10, which can be disadvantageous if the stock rallies sharply. Also, the breakeven price will be the effective purchase price which, in our case, is ₹97. If the stock remains below this price on expiry, the trade will result in a loss. Below is an example.

Price falls to ₹95: In case the price falls to ₹90, the call option will not be exercised. The fund manager will lose ₹5 on the stock (₹100-95). However, she will still get the ₹3 premium, thus limiting the overall loss to ₹2 (Loss of ₹5 on the stock plus gain of ₹3 on call premium).

With respect to downside risk, the loss will be upto the extent of the decline from ₹97, the breakeven or the effective buy price. So, the maximum loss in our example will be ₹97.

Thus, in three of the four scenarios, the fund manager stands to make gains and an accrual to the fund in the form of written premium and capital gains as well in certain cases. Losses are also limited. As with stocks, option trade can also be done with indices.

Derivatives give equity taxation benefit

One of the key benefits of using derivatives in mutual funds is to get the benefit of equity taxation. Since exposure to derivatives in a mutual fund is treated as equity, it benefits three categories of funds — arbitrage, equity savings and balanced advantage — in gaining an advantage.

In the case of equity savings and balanced advantage funds, this is more pronounced. For example, these funds could have only 30-50 per cent exposure to cash market stocks. But they may have arbitrage/derivative hedging exposure to the tune of, say, 30-40 per cent. Therefore, the gross equity exposure exceeds 65 per cent by totalling cash and derivative exposure, thus qualifying for equity taxation.

So, long term (more than 12 months) capital gains are taxed at 10 per cent (plus surcharge and cess) beyond ₹1 lakh. Short-term capital gains are taxed at 15 per cent (plus surcharge and cess).

On either count, the taxation rules are favourable when compared to debt funds, where gains are taxed at the applicable marginal slab irrespective of the holding period. So, a 6 per cent return on an arbitrage fund would translate to 5.4 per cent post tax (without cess and surcharge) after one year. But in a liquid fund, that would mean only 4.2 per cent post tax, if the person falls in the 30 per cent slab.

So, even of an arbitrage fund returns that are close to what liquid funds generate, the former scores on account of better taxation.

Of course, for investors, equity savings and arbitrage funds may be more suited for short and medium-term goals over 1-3 years. The balanced advantage category , given its deeper mandate, could be useful even for goals of around five years.