Mutual funds largely eschew derivatives play

Since its inception in 2000, the derivatives market has emerged as a major market segment.
This type of trading allows market players to hedge their exposures or take bets depending upon their view on market situations. With Sebi allowing mutual funds to participate in derivatives, fund managers do take positions through futures and options in order to hedge their positions. It also allows investment managers to take arbitrage advantage of mis-pricing arising out of two different markets i.e. cash market and derivatives market, thus, locking the profit in case the price differs in both the markets.
While the advantages of trading in the derivative segment are many, mutual funds have not gone overboard in investing in this segment. The total exposure of mutual funds in derivatives market at the end July 2009 was close to Rs 1,360 crore. When compared to the volumes clocked in the derivative markets, mutual funds participation is marginal.
Investing in the derivative segment is fraught with its own set of risks, as a result of while, Sebi permitted mutual funds to dapple in the derivatives market. It has done this with some wise restrictions in place. The maximum net position by mutual funds in derivatives has been capped to the extent of 50% of the portfolio.

Trend

The primary reason why fund managers invest in futures and options segment is with the aim to hedge risks. Derivatives are used as an instrument to minimise the risk exposures and limit the degree of fluctuations in prices, which is rampant during a bear market. On the other hand, in a bull phase, the managers are less averse to risk and hence do not hedge as extensively. Hence, theoretically, the exposure in derivatives would ideally be higher in the bear phase while it can drop down during a bull phase.
For the worst of the bear phase -- marked between January 2008 and March 2009 -- the exposure to derivatives witnessed a large increase. In case of ICICI Prudential Mutual Fund, the exposure into the derivatives segment climbed from 1.77% as a proportion of equity assets under management in January 2008 to 5.86% in March 2009. On the other hand, even in the current improved market conditions, DSP Black Rock Mutual Fund allocated 12.52% of its equity assets to derivatives during July 2009.
On an average, the highest allocation in the derivative segment across asset management companies was in the month of November 2008, with four fund houses allocating anywhere between 11.50% and 14% of their equity assets to derivatives.
The theoretical assumption of higher exposure to derivatives in bad times and a significant drop in derivative positions in better times is vindicated by the holdings of mutual funds between March 2009 and July 2009. Since markets began looking more upbeat after the Lok Sabha elections, the assets allocated to derivatives have also drastically reduced, as have the number of schemes hedging through derivatives.
Moreover, before January 2008, there were hardly any positions in the derivatives segment, with barely 10 diversified equity schemes dappling in derivatives. On the other hand, there have also been some AMCs such as HDFC Mutual Fund, Reliance Mutual Fund, SBI Mutual Fund, UTI Mutual Fund and few others which have not ventured into this segment over the past two years.

Performance

In order to assess whether the strategy of investing in derivatives works or not, we segregated the schemes which invested in derivatives and those which did not. Between January 2008 and March 2009, out of 187 diversified equity schemes, as many as 75 invested in futures and options. Moreover, the returns delivered by these 75 funds are not very different from the remaining diversified equity funds. The range of returns is also comparable. The funds which invested in derivatives on an average lost 59.89% while the other diversified equity funds lost 55.75% on an average.
A look at the near-term performance since March 2009 also shows that the returns of these schemes have not been dented drastically over the recent uptake in equity markets. One of the strategies of investing in derivatives is that of gaining from the mis-pricing between the cash and the derivatives market.
Using this strategy, AMCs have floated arbitrage schemes. Unlike the run-of-the-mill equity funds, this class skirts the 'high risk' tag that is synonymous with equity investment. But then again, the returns are also much lower and are more similar to what a debt-oriented mutual fund would produce. The returns for equity arbitrage schemes over the past year have been in the range of 5-10%.
While the use of derivatives by mutual funds as a hedging mechanism is a popular one, in the Indian context, their participation has been unimpressive. It is unlikely the diversified equity class of funds will exploit this option if the uptake in equity markets persists. However, with the success of the arbitrage category of funds, the share of mutual funds investing in this market segment is likely to change in the long run.

Source: http://www.dnaindia.com/money/report_mutual-funds-largely-eschew-derivatives-play_1284900