Making sense of MFs’ coated name technique

A coated name is an choices technique wherein the individual writes (sells) a name possibility on the inventory that’s already held within the portfolio. The name possibility sellers (fund homes right here) can generate revenue within the type of possibility premium, which is paid by the choice purchaser.

“It is true that derivatives can be utilized to take a position, to leverage and to explode. However, it’s also true that derivatives can be utilized to hedge and to handle danger. Just like a kitchen knife can be utilized to stab folks and in addition be used to chop fruit and veggies, derivatives may have a number of makes use of,” wrote Rajeev Thakkar, CIO, PPFAS Mutual Fund, in a communication to investors when the fund house enabled the covered call strategy in October 2020

The increased interest amongthe fund houses in the covered call option in the last one year is because this strategy allows fund managers to generate additional income, especially, in a falling or sidewise market. The latter refers to a phenomenon where the stock market shows no clear trends and is typically volatile.

To put the covered call options trend in perspective, in June 2022, when the market was still witnessing sell-off pressure, PPFAS Flexi Cap Fund entered into 3,437 covered call contracts which generated gains of ₹2.45 crore in that month. This is against just nine contracts that it had entered in May 2021, generating a net profit of only ₹35,291.

“The higher the volatility, the larger the benefit of covered calls,” mentioned Feroze Azeez, deputy CEO, Anand Rathi Wealth.

Though the achieve made by the PPFAS fund home in June 2022 was minuscule in comparison with its belongings beneath administration (AUM) of about ₹22,300 crore in that month, the fund home believes that it’ll add a bit to the fund’s yield in the long term. This view has additionally been echoed by DSP Mutual Fund, which has been utilizing the coated name technique in its Quant Fund, of late.

“We haven’t even reached near the permissible restrict for coated calls in our flexi-cap fund. Further, the thought of utilizing the technique is to not generate materials positive factors, however to generate some further returns which in any other case wouldn’t have come to us,” mentioned Raunak Onkar, analysis head & co-fund supervisor at PPFAS MF.

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Also, it is very important do not forget that using a coated name technique by the fund homes won’t change a scheme’s basic type of investing and constructing the portfolio.

How it really works

When a fund supervisor expects the worth of any inventory within the portfolio to fall or stay sideways within the quick run, writing a name possibility helps in making further returns whereas persevering with to carry the inventory.

For instance, say Reliance Industries Ltd (RIL) is a part of a scheme’s portfolio purchased on the present market worth of ₹2,527. The fund supervisor believes that the inventory won’t see any important uptrend within the quick run and writes (sells) a month-to-month name possibility at a strike worth of ₹2,900.

The name possibility purchaser will get the ‘right’ to purchase the share at ₹2,900 on the expiry date no matter be the market worth on that day. The possibility purchaser pays some quantity — an possibility premium of ₹5.5 per share— to the fund supervisor for the ‘right’.

Let’s see what the achieve or loss the mutual fund scheme makes in several market situations.

Scenario 1: When the market worth on the expiry day is lower than or equal to ₹2,900

The name possibility won’t be exercised and the choice premium of ₹ 5.5 per share is the extra return for the fund. The fund supervisor continues to carry the shares of RIL; name choices get exercised solely when the market worth is greater than the strike worth.

Scenario 2: When the market worth on the expiry day is greater than ₹2,900. Let’s put it at ₹3,000 .

In this case, the decision possibility will get exercised – the fund supervisor has to promote the share at ₹2,900 to the choice purchaser. The precise revenue or loss to the scheme on sale is (sale worth minus the associated fee worth plus the choice premium acquired) equals ₹378.5 ( ₹2,900 – ₹2,527 + ₹5.5).

There’s a possibility loss in state of affairs 2 for the scheme— had the fund supervisor not entered right into a coated name technique, the share might be offered for ₹3,000 available in the market, which ends up in a capital achieve of ₹473 ( ₹3,000 – ₹2,527). The distinction of ₹94.5 ( ₹473 – ₹378.5) is the chance loss for the fund.

This occurred in July with PPFAS’s Flexi Cap fund, whereby some Coal India shares that the scheme owned had been offered as a part of the coated name (though at a revenue to the acquisition worth).

Mitigating dangers

One of the large dangers with the coated name technique is that it limits the investor’s potential to seize the potential upside of the inventory.

In the above instance, any worth appreciation of RIL shares past the strike worth is a chance loss to the fund supervisor. However, consultants consider that the regulatory measure may restrict uncommon losses from the technique.

According to market regulator Sebi, coated calls might be written solely on Nifty 50/BSE Sensex shares. Further, a fund supervisor can not write choices on greater than 30% of shares of any firm held within the portfolio. Besides, the whole notional worth (strike worth in addition to premium worth) of name choices written by a scheme shall not exceed 15% of the market worth of fairness in that scheme.

Fund homes say there are inner measures as effectively that they adjust to to scale back the danger of taking coated calls.

According to DSP Mutual Fund, “to scale back the danger of coated name methods, we’ll write coated calls solely the place the strike worth is about 5-10% above the present inventory worth (with the idea that 5-10% uptrend for an already over-valued inventory is unlikely within the quick run, which might be beneficial to a fund supervisor’s name.).”

The fund house also highlighted in its communication on the covered call strategy that it will write calls with a near-month expiry and not long-dated options as the uncertainty increases with further future calls. “We also avoid writing covered calls in the face of overall macro uncertainty such as elections where outcomes are not predictable.”

Onkar from PPFAS Mutual Fund mentioned, “we’ll by no means promote a coated name the place the strike worth is decrease than our buy worth.” In our example, ₹2,527 is the purchase price for Reliance; as per PPFAS, the strike price of covered call will be always more than ₹2,527. This is because, even if the call goes wrong and shares have to be sold, the transaction will not lead to actual capital loss.

The fund house also said that it tries to square off the position before the expiry date, if it thinks the covered call is not working in its favour.

Meaningful impact?

“This strategy surely helps in generating additional income, but it will be meaningful only if the scheme is able to write calls on large holdings of the portfolio,” mentioned Kirtan Shah, founder and CEO, Credence Wealth Advisors.

As proven within the desk, the positive factors made by PPFAS mutual fund, as disclosed by the fund home, is minuscule in comparison with its AUM. Also, within the instance, as highlighted within the desk, in a hypothetical state of affairs of coated calls going proper nearly on a regular basis, the extra revenue contributes simply 0.8% every year to the whole worth of the fund.

Note, that is simply an instance and it may extensively differ primarily based on the premium quantity which depends on varied elements reminiscent of strike worth, the time interval till the expiry date, volatility, company actions and earnings, and expectations of the sector.

On the opposite hand, if the decision goes mistaken, the chance price might be increased for the scheme. “I’ve been doing name writing for fairly a while. We may have the ability to earn cash 11 out of 12 occasions, however that one time that the inventory strikes up, it in all probability may take away a really giant share of what you in any other case would have made by holding on to the inventory,” added Shah.

Most of the distributors and investment advisors Mint spoke to say that they have not been considering covered call strategy as a factor in analysing the fund, as there is no material impact of such strategies on fund returns.

“In terms of a covered call, a retail investor must largely see whether there is a transparent communication from the fund house on its usage than evaluating the nitty-gritty of covered calls taken by the fund manager,” added Shah.

Yet, there appears to be no uniformity amongst fund homes when it comes to disclosures on coated calls entered throughout a month. PPFAS Mutual Fund has been offering detailed disclosure (as proven within the desk) amongst all we checked and communicated it to traders when the calls went mistaken (for instance, the decision on Coal India).

One must verify ‘detailed portfolio disclosures’ or fact-sheets to acquire particulars on the coated calls entered into by the scheme, other than direct communication from the fund home.

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