Which Indian Mutual Funds Employ Options in their Portfolios?

Abstract

The use of derivatives by mutual funds is closely monitored by regulators across markets. Indian market regulator, Securities and Exchange Board of India (SEBI) has recently taken measures to allow Indian mutual funds to underwrite call option contracts under certain strict conditions28. In general, call options refer to an agreement between two parties where the buyer gets the right to buy an underlying asset in the future at a predetermined price whereas the seller has the obligation to sell the underlying. Till recently, mutual funds were allowed only to take positions in derivative contracts but can now write option contracts. However, this is allowed under covered call strategy and also restricted to index constituents of NIFTY 50, and SENSEX. This implies that they cannot write options without being long on the underlying. Derivative contracts, especially option contracts are a very useful tool available to mutual funds in several ways. It is a fact that mutual funds herd and Indian mutual funds are no exception. However, we don’t have concrete information on how different mutual funds employ different types of derivatives and to what extent they use them to enhance their portfolio performance. It has been discussed in the popular press that mutual funds using options have several advantages and these funds are seen as better investment funds. These funds have superior risk management ability; demonstrate superior performance. Other important arguments put forward by popular academic research which supports the above are; informed investors with their superior information find it attractive to trade in the options markets. Hence, mutual funds which use options integral to their trading strategies are informed investors that best use their superior information to attain stock specific exposure with a fraction of a cost that they have to otherwise pay for directly taking exposure in the stocks. Also, using options efficiently requires in-depth knowledge of option pricing and working of options markets. These qualities are generally beyond the orthodox skills of mutual fund managers and hence suggest that funds which use options effectively are sophisticated funds. Information on these aspects will throw light on the advantages and disadvantages of derivatives use by mutual funds and help regulators to take appropriate measures to improve the overall health of the mutual fund industry. The heterogeneous use of derivative instruments by different mutual funds impact their portfolio return and risk characteristics. In this context, I analyze some of the major Indian mutual funds in terms of assets under management to understand their use of options contracts in their portfolio strategy and their performance.