Many mutual fund investors today ask if they should jump to Specialised Investment Funds (SIFs). This is because their sophisticated derivative strategies combined with mutual fund-like regulation and taxation sound like the best of both worlds. In our earlier article on SIFs, we explained how SIFs differ from mutual funds and how long-short strategies work.
Since many fund houses have now launched their SIFs, in this report we take a detailed look at the derivative strategies they implement, how they aim to make money, the risks involved, and how these compare with the derivative strategies used by mutual funds.
What SIFs are not
In the minds of many retail investors, derivatives = large profits. This is in fact why they are interested in SIFs, but they get it wrong. SIFs use some derivative strategies that are restricted in standard mutual funds. However, this does not grant them the liberty to pursue “hedge fund-style” high-risk strategies aimed at outsized speculative gains. While SIFs have more flexibility on derivative use, leverage is strictly capped, and the short leg of a portfolio cannot exceed 25% of total assets. This means SIFs can’t grow your money at double the market returns or more, as many imagine.
Although a wide range of derivative strategies can be implemented in SIF, not all funds use all of them. Recent fund launches suggest that the current crop of SIFs plan to use strategies that work best in flat or declining markets, essentially helping to curtail downside risk. On the flip side, these strategies can also incur losses.
Derivative strategies used by SIFs
Below, we analyze a few common derivative strategies outlined in recent SIF prospectuses. This list is not exhaustive, and funds may employ other strategies.
#1 Bear Put Spread
In this strategy, the investor buys and sells put options simultaneously. The put option bought has a higher strike price than the put option sold.
How it makes money: Suppose a stock is trading at Rs. 1,000. The investor: Buys a put option with a strike price of Rs. 1,000. Sells a put option with a strike price of Rs. 950. Assume the cost of buying the Rs. 1,000 put is Rs. 50. Premium received from selling the Rs. 950 put is Rs. 30. Net cost of the strategy = Rs. 50 – Rs. 30 = Rs. 20.
If the stock closes below Rs. 980 at expiry, the strategy makes a profit.
When it works best: This strategy works best when a stock is expected to fall moderately. If the investor had only bought the Rs. 1,000 put for Rs. 50, the stock would need to fall below Rs. 950 to make a profit. By selling the Rs. 950 put and receiving Rs. 30, the break-even improves to Rs. 980. This increases the probability of profit in case of a moderate decline. However, selling the lower-strike put also limits the gains. If the stock falls sharply below Rs. 950, gains are capped because the loss on the sold put offsets further gains on the bought put.
Nature of gains and losses: This strategy has limited gains and limited losses. Maximum loss happens if the stock expires at or above Rs. 1,000. In this case both options expire worthless. Loss = Net premium paid = Rs. 20.
Maximum gain happens if the stock expires at or below Rs. 950: Gain on Rs. 1,000 put = Rs. 1,000 – Closing price. Loss on Rs. 950 put = Rs. 950 – Closing price. The maximum spread between strikes is Rs. 50. Net maximum gain = Rs. 50 – Rs. 20 = Rs. 30.
For example, if the stock closes at Rs. 800: Gain on Rs. 1,000 put = Rs. 200. Loss on Rs. 950 put = Rs. 150. Net option payoff = Rs. 50. After adjusting for the Rs. 20 net premium paid: Net profit = Rs. 30.
#2 Bear Call Spread
Similar to a bear put spread, a bear call spread involves buying and selling call options with the same expiry. In this case, the call option bought has a higher strike price than the call option sold.
How it makes money: Assume the stock price is Rs. 1,000. The investor sells a call option with a strike price of Rs. 1,000. Buys a call option with a strike price of Rs. 1,050. Assume the premium received from selling the Rs. 1,000 call is Rs. 50. Premium paid for buying the Rs. 1,050 call is Rs. 20. Net premium collected = Rs. 50 – Rs. 20 = Rs. 30. The break-even point is: Rs. 1,000 + Rs. 30 = Rs. 1,030. If the stock closes below Rs. 1,030 at expiry, the strategy makes money.
When does this strategy work best? This strategy works best when the stock remains below the lower strike price (Rs. 1,000 in this example). In that case, both options expire worthless and the net premium collected (Rs. 30) is retained as profit.
It is typically used when the investor expects the stock to stay flat or decline moderately.
Nature of gains and losses: This strategy has limited gains and limited losses. Maximum gain happens if the stock closes at or below Rs. 1,000, both options expire worthless. Gain = Net premium collected = Rs. 30.
Maximum loss happens if the stock closes at or above Rs. 1,050. For example, if the stock closes at Rs.1,300; loss on Rs. 1,000 call is Rs. 300. Gain on Rs. 1,050 call is Rs. 250. Net loss from calls is Rs. 50. Since Rs. 30 was already collected as premium: Maximum loss = Rs. 50 – Rs. 30 = Rs. 20.
Selling a naked call would expose the investor to unlimited losses if the stock rises sharply. Buying the higher-strike call caps this risk and makes this strategy’s losses limited.
#3 Short Straddles
A short straddle involves selling both a call option and a put option with the same strike price and the same expiry. The strike price is usually close to the prevailing market price at the time of initiating the trade.
How it makes money: Suppose a stock is trading at Rs. 1,000. The option writer sells both a call and a put option with a strike price of Rs. 1,000. Assume both options are sold at Rs. 20 each. The total premium collected is Rs. 40.
Now assume that at expiry, the stock price is Rs. 1,005. The put option expires worthless. The call option costs the investor Rs. 5. The net profit in this case is: Premium received (Rs. 40) – Call payout (Rs. 5) = Rs. 35.
When does this strategy work best? This strategy works best when volatility is low and the stock price remains range-bound. In the above example, the break-even points are 960 and 1,040 (1,000 -/+ 40). If the stock closes within this range at expiry, the strategy makes money. The maximum profit (Rs. 40) occurs if the stock closes exactly at Rs. 1,000 on expiry. If the stock closes below Rs. 960 or above Rs. 1,040, the strategy results in a loss.
Nature of gains and losses: This strategy has limited gains but potentially large losses. In this example, the maximum gain is limited to the premium collected (Rs. 40). However, losses can be substantial. For instance, if the stock closes at Rs. 1,300 at expiry: Loss on call is Rs. 300. Net loss = Rs. 300 – Rs. 40 = Rs. 260
Since a stock’s upside is theoretically unlimited, the potential loss on the upside is also unlimited. Losses can also occur in the event of a sharp downside move.
#4 Short Strangle
A short strangle is similar to a short straddle. However, in this strategy, both the call and put options sold are out of the money.
How it makes money: Suppose a stock is trading at Rs. 1,000. The option writer sells: A call option with a strike price of Rs. 1,050. A put option with a strike price of Rs. 950. Assume both options are sold at Rs. 2 each. The total premium collected is Rs. 4.
If the stock closes at expiry at any price between Rs. 950 and Rs. 1,050, both options expire worthless. The full premium of Rs. 4 is retained as profit.
When does this strategy work best? Like a short straddle, a short strangle works best in a low-volatility environment where the stock price remains range-bound.
Since the options sold are out of the money, the premium collected is lower compared to a short straddle. However, the probability of both options expiring worthless is higher. In the above example, that would mean earning the full Rs. 4.
Nature of gains and losses: This strategy also has limited gains and potentially large losses. In the above example, the maximum gain is limited to the premium collected (Rs. 4). Losses can be substantial if the stock makes a large move in either direction. For instance, if the stock closes at Rs. 1,300 at expiry; Loss on call = Rs. 1,300 – Rs. 1,050 = Rs. 250. Net loss = Rs. 250 – Rs. 4 (premium collected) = Rs. 246.
Here too, since a stock’s upside is theoretically unlimited, the potential loss on the upside is unlimited. On the downside also, losses happen if the stock falls below Rs. 950.
Derivative strategies used in MFs
Although SIFs have brought derivative strategies into focus, mutual funds have been using derivatives already. Two of these existing derivative strategies are also used in SIFs.
#1 Equity Arbitrage
In this strategy, the investor buys a stock in the cash market and simultaneously sells its futures contract at a higher price.
How it makes money: Futures contracts are usually priced slightly above the underlying stock price due to the cost of carry, which broadly reflects prevailing money market interest rates. For example, if a stock is trading at Rs. 1,000, a one-month futures contract might trade at Rs. 1,005. An arbitrageur can: Buy the stock at Rs. 1,000. Sell the futures contract at Rs. 1,005. At expiry, the futures price converges with the spot price. The investor delivers (or squares off against) the stock and pockets the Rs. 5 difference, independent of whether the stock has risen or fallen.
When does the strategy work best? This strategy is market neutral. The direction of the stock price does not determine profitability, as the price difference is locked in at the time of execution. However, profitability depends on cost of capital, availability of spreads, transaction costs, and liquidity.
When short-term interest rates are high, futures premiums (cost of carry) tend to be higher, increasing arbitrage spreads. Security-specific demand for futures contracts can also create temporary opportunities.
Nature of gains and losses: Theoretically, if executed properly and held until expiry, the spread is locked in. In practice. Risks include Liquidity, and counter party risk. Returns from equity arbitrage are typically modest. If opportunities are consistently available and capital is efficiently redeployed, returns tend to be in the range of short-term money market rates.
#2 Covered Calls
In this strategy, the investor sells a call option on a stock that they already own.
How it makes money: Suppose a stock that the investor holds is trading at Rs. 1,000. The investor sells a call option with a strike price of Rs. 1,050 and receives a premium of Rs. 2. If the stock closes below Rs. 1,050 at expiry, the option expires worthless and the investor retains the Rs. 2 as additional income. If the stock closes above Rs. 1,050, the investor will have to sell the stock at Rs. 1,050. In that case, the total effective sale price becomes: Rs. 1,050 + Rs. 2 = Rs. 1,052.
When does this strategy work best? This strategy works best when the investor expects the stock to remain range-bound or rise only moderately. For long-term buy-and-hold investors, covered calls can provide additional income, particularly when short-term upside appears limited.
Nature of gains and losses: Unlike naked option selling, risk in a covered call is mitigated because the investor already owns the stock. The maximum gain from this strategy is the premium collected for selling the call, Rs.2 in the above example. Do note this is excluding any gains from the underlying stock.
On the downside, the limitation here is opportunity loss. For instance, if the stock closes at Rs.1,300 at expiry, the investor must sell at Rs.1,050. Adding the Rs.2 premium, the net sale price is Rs.1,052, thereby forgoing an additional Rs.248 profit.
This strategy does not create extra cash loss from the option leg itself. The investor still bears the downside risk of holding the stock, but this is not related to the option sold.
Investor takeaway
While SIFs have greater freedom with derivative strategies compared to mutual funds, this may not mean outsized returns. Primary returns are still expected to come from the “long leg” of the SIF portfolio, where the fund manager’s stock selection skills only will matter.
In the equity space, mutual funds will continue to challenge SIF on returns, especially during strong market rallies as their mandated “long-only” stance works to their advantage. While equity SIFs can theoretically outperform in sideways or falling markets, whether this advantage is sufficient to beat mutual funds over the long run remains to be seen.
Regarding hybrid long-short SIFs, they could theoretically outperform categories like Balanced Advantage Funds (BAFs). The derivative strategies SIFs implement can potentially offer higher alpha than BAFs, which rely primarily on simple arbitrage on the derivative side. However, this potential for higher returns comes with increased risk – some of these strategies may generate steady income for long periods but incur steep losses during Black Swan events.
Furthermore, selecting a SIF based on its derivative profile is difficult due to lack of transparency on the actual strategies employed. There are currently no mandatory disclosures specifying which real-time strategies are being employed. Since these derivative positions are often short-term (sometimes closed within a month) and SIFs only declare portfolios bimonthly, the fund may have already entered and exited the strategy within the interval. Even with the portfolio disclosure in hand, identifying the underlying strategy is hard unless it is explicitly stated.
As with any new investment concept, a wait-and-see approach is prudent. Once SIFs have navigated a full market cycle and survived periods of high volatility, we will have the data necessary to judge their performance against time-tested mutual funds.
