How SIFs Use Derivatives to Protect Capital and Manage Volatility

Specialised Investment Funds (SIFs) use derivatives as important tools. They help protect capital and manage volatility. This gives investors better options than traditional mutual funds. Unlike mutual funds, which have strict limits on derivative use primarily for hedging, SIFs enjoy regulatory flexibility to deploy derivatives more tactically, including for hedging, short-selling, and strategy execution, within prescribed risk controls and asset exposure limits.

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Derivatives for Capital Protection and Volatility Management in SIFs

Derivatives are financial contracts whose value derives from underlying assets such as equities, bonds, commodities, or indices. SIFs use derivatives primarily for hedging—the practice of offsetting potential losses in one asset by taking an opposite position in a derivative. For example, index futures and options enable SIFs to protect against market downturns by locking in prices or providing insurance against adverse price movements.

This hedging role is key to reducing downside risk. By strategically buying put options or using options strategies like spread collars, SIFs can limit losses in their portfolios during volatile or bearish market phases while still keeping some upside potential. These derivative tactics act as “insurance” for the portfolio, accepting a premium cost to ensure stability in tough markets.

Enhanced Flexibility Compared to Mutual Funds

Where mutual funds typically restrict derivatives to risk management without leverage or short selling, SIFs can take unhedged short positions up to 25% of net asset value (NAV) using derivatives. This flexibility lets SIF managers actively manage exposure to both rising and falling markets, improving volatility management and capital preservation under varying market conditions. Tactical asset allocation, such as sector rotation and long-short equity strategies, is facilitated by derivative use, allowing dynamic risk-adjusted returns.

These derivative strategies help SIFs maintain a balanced risk profile through diversification across asset classes including equities, debt, commodities, and REITs/InvITs. Regulatory limits ensure that exposure to any single issuer or sector is capped, which when combined with derivative hedging, protects the fund from concentrated risk and market instability.

Types of Derivative Instruments Used

SIFs use a variety of derivatives, including:

• Futures contracts to secure future prices or protect against market drops with exact pricing.
• Options (puts and calls) to protect portfolios or carry out complex strategies like straddles and iron condors, which seek profits in both volatile and stable markets.
• Swaps, including interest rate swaps, to handle interest rate risk or currency exposure in global portfolios.
• Forwards to protect against currency risks or changes in commodity prices.

By capping derivative exposure generally at 100% of NAV and embedding strict risk management protocols, SIFs use these instruments not for speculative excess but for disciplined risk control and capital preservation.

Tactical and Strategic Benefits for Investors

The use of derivatives improves SIFs’ ability to:

• Protect capital during downturns and lower portfolio volatility.
• Generate alpha through market-neutral, long-short, or volatility arbitrage strategies.
• Adjust exposures quickly in response to market signals or economic events, preserving returns in both bull and bear markets.
• Access investment strategies usually unavailable in traditional mutual funds, expanding portfolio diversification and tactical flexibility.

Investors in SIFs benefit from this advanced risk management toolkit by potentially experiencing reduced downside during market shocks, while preserving upside participation, making SIFs well-suited as tactical investment components within diversified portfolios rather than core holdings.

Summary

In summary, SIFs use derivatives widely and flexibly to protect capital and deal with volatility. They use futures, options, and swaps to hedge risks, guard against market downturns, manage interest rate and currency risks, and create complex trading strategies. This use of derivatives sets SIFs apart from mutual funds. It lets them take both long and short positions and adjust portfolios as market conditions change. Regulatory frameworks ensure that derivatives are used within safe exposure limits. This improves risk management and potential returns. For investors looking to protect their capital and keep volatility in check, SIFs offer a strategic way to manage portfolios actively.