Last week, PPFAS issued this release informing of changes in scheme attributes. They proposed to add “Writing of Covered Call Options under a Covered Call Strategy”.
Let us understand what it means and how it might affect us. And more importantly, what should we do about it – stay invested or not? Let us break down this scary looking thing into bite sized pieces. One by one.
Mutual Funds are long only investment vehicles. They buy and hold securities in anticipation for prices to rise. (In financial markets, the act of buying is called going long. Hence the term, long only). Naturally, all long-only funds make money only when the markets go up. But markets don’t always just go up. They can go up, go down or go sideways. Long-only funds make money only in first instance. In other two instances, they will be sitting ducks. In such cases, they have two options. Either exit their holdings and wait for opportune times to re-enter or just bide time for markets to re-bound.
What if there was a way that allows fund managers to make money in sideways market. Or an option that lets them not to lose money (or lose relatively less) when markets go down? Well, there is and it can be done by using derivatives. Writing covered calls is one such strategy, which the AMC has proposed to add. Let us now understand what it means.
Just like equity, derivatives are also traded on the stock exchange. “Derivatives” is a very broad, generic term for something whose price is derived from something else (an underlying). Calls and Puts are one sub-segment of derivatives. It is impossible for me to go into nuances of Derivatives or Options in this write-up. I will try to cover the basics of it but also limit it just so to understand this attribute change. So, back to the topic – Call Options are derivative instruments which give the holder the right to buy. The keyword here is “Right”. Not an obligation. What does it mean? Let us try to understand this seemingly complex derivative instrument with an everyday example.
Say, your grocery store gives you a coupon that can be used on your next purchase. And the coupon says, you can buy Onions at Rs.50, upto 2Kg, before the end of month (little cliched but bear with me). Now consider this scenario: between the time you got the coupon and your next grocery run, vegetable prices crashed. Onions are available in retail at Rs.40 a kg. It makes no sense for you to use your coupon and buy onions at Rs.50. You might as well buy them from the open market at Rs.40. So this coupon won’t be used (goes un-exercised). However, if the market price is Rs.55 (or higher), you would definitely want to use that coupon. So, connecting this examples with Call Option, you had the right to use the coupon but not an obligation. You would “exercise” your “right” to use it, if it is financially advantageous (if market price is higher than coupon price). Otherwise you would throw it in the bin (let it expire).
That was an over-simplified example of a Call Option. Ofcourse, there are many more nuances that are beyond the scope of this article. Now that basics are covered, let us move to next bit. So what are covered calls and how does it work? A Mutual Fund has a portfolio, which they bought for long term holding. However, they are not sure about the short term market movements. They want to hedge their position against those and if possible, make some money in the bargain. So, they sell (write) call options against that portfolio. They sell Out of The Money (OTM) options. Let us understand this bit with an example.
Say, current price of ITC is Rs.187. All Call Options more than 190 are OTM options. The fund might sell 200 Call (or 210 or higher) with an assumption that price of ITC might not reach 200 by end of the month (or in that derivative expiry). Since they sold options, they receive option premium. All those premium received is income for the fund. Three scenarios can play out here: One, price of underlying (ITC) does not reach 200. AMC gets to keep the premium. Two, if the price does reach 200, they still keep the premium but have to handover that much quantity of equity stock from portfolio. Three, if the stock continues to run beyond 200, then the fund will lose out. In this scenario, they might have to buy it back at a higher price.
So why does PPFAS need to add this provision? Well, the simple answer is – to reduce volatility and if possible, earn few extra basis points, especially in sideways market. Similar reason that they diversified geographically. Derivatives are not new for them. They have been hedging their foreign portfolio exposure by way of currency shorts. And doing it well.
What are the stocks on which the AMC can write Call Options? The regulator (SEBI) has restricted covered call writing for Mutual Funds to Nifty 50 and BSE Sensex stocks. From the latest portfolio, we can gather that the fund can write call options on these 7 stocks:
Can this list change next month? Certainly YES. As of last month, these 7 stocks constitute just over 26% of the AUM. Does it mean that the AMC can write options on the entire 26% of AUM? Definitely NO. By regulations, they can write just 30% of this shortlist. Meaning, 30% of this 26% – which is about 8% of AUM or about 360 Cr. In all probability, even this number might not be reached in near future. Why – lets look at that now. At the time of writing this, the total value of all the Call Options of these 7 stocks was just about 130 Cr. Meaning, if PPFAS was the seller of all the outstanding Calls on these 7 stocks (which is an absurd assumption in itself), then this would cover just about 3% of the AUM. Well short of the limit of 8%. This should get you an idea of how much exposure the AMC might take, if they do take.
This is expiry wise breakup of the value of all Call Options of these 7 stocks (in Rs. Cr.)
The question on everybody’s mind – what to do next? Well, I certainly cannot answer that but I can present my views: fund managers and trustees of PPFAS have acted very responsibly. They have skin in the game. About 4% of the fund is held by employees and directors (more than any other AMC). They did not deviate from the mandate of value investing. They still maintain a selective portfolio of about 25/30 stocks. On inflows, they just keep buying more of the same stock. And I assume they would continue to do all of these, in future as well. In addition, there are two more reasons not to panic from this derivative clause. One, derivatives is not new for them. Second, just because something is available, it need not be used. As an example, they had added REITs to their investment universe last year but yet to invest there. Because they did not find sufficiently good opportunities there. Going by history, my assumption is that fund managers will continue to be cautious and conservative even while using this new feature.
So my opinion is – don’t exit just for the heck of it. Or because your friend/neighbour is doing so. Understand the nuances. Talk to your trusted advisor (if you don’t have one, then get one). And take an informed decision. If your asset allocation suggests equity allocation, then continue to stay invested. As usual, we will continue to monitor developments. Until then, Status Quo.