Can Mutual Funds Invest in Options and Futures

Mutual funds in India are permitted to trade in futures and options (F&O) in accordance with the regulatory guidelines issued by the Securities and Exchange Board of India (SEBI). Mutual fund schemes may use derivatives for hedging, portfolio exposure management, arbitrage, and other permissible strategies, including covered-call strategies, as applicable.

For investors, the purpose and size of a scheme’s derivative exposure are important. SEBI has defined rules on permissible strategies, exposure limits, position limits, and disclosures that regulate the use of these instruments by mutual fund schemes.

In this article, we will discuss the use of futures and options by mutual funds and the SEBI rules governing derivative exposure.

What Are Derivatives, Futures, and Options?

Derivatives are financial contracts whose value is based on an underlying asset or benchmark. This can be a stock, market index, commodity or currency. Fund managers can use derivatives to alter the risk profile of the portfolio and to alter the market exposure within the scope of the approved scheme strategy.

Futures are contracts to buy or sell a specific asset at a set price on a future date. Index futures can be used by a mutual fund manager to hedge part of the portfolio against a short-term decline in the market, or to change the scheme's market exposure without the need to sell the underlying holdings.

Options allow the buyer to buy or sell an underlying asset at a certain price, within a certain period. Options may be used in permitted hedging and covered-call strategies for mutual funds. A scheme may use a covered-call strategy by writing call options against eligible underlying shares it already owns, subject to SEBI's prescribed conditions. 

Why Do Mutual Funds Use Futures and Options?

Fund managers use futures and options to hedge their portfolios’ exposure without having to constantly buy and sell the underlying securities. Depending on the scheme and the allowed strategy, derivatives may help to achieve a number of objectives related to portfolio management:

• Hedge market risk: A fund manager can hedge, or offset, the impact of a short-term decline in the market by using index futures while still maintaining the underlying equity portfolio. Gains on the futures position can compensate for some of the loss in value of the portfolio.
• Portfolio exposure management: Futures allow fund managers to quickly adjust market exposure without disrupting existing positions. This can be useful when the manager wishes to temporarily change exposure without having to sell and then repurchase individual stocks.
• Implementing arbitrage strategies: Arbitrage funds profit from price differences between the same or similar securities in the cash and derivatives markets. The paired positions offset the influence of overall market direction.
• Earning premium income: Where allowed, a plan may write covered calls on eligible stocks already held in the portfolio. The fund collects an option premium but agrees to a cap on some of the upside potential from those holdings.

These uses help fund managers to manage risk and exposure within the investment strategy of the scheme and applicable SEBI rules.

SEBI Regulations Governing Mutual Fund Derivative Investments

SEBI regulates mutual fund derivative activity in India, while AMFI is the mutual fund industry's representative body. If you want to check what a specific scheme is allowed to do, then read its scheme information document.

Exposure Limits You Should Know

Some of the major exposure caps and restrictions under the SEBI framework are:

• Total gross exposure cap: aggregate gross exposure across equity, debt, derivative positions and other specified permitted securities and assets shall not exceed 100% of the net assets of the scheme, subject to applicable SEBI provisions.
• Option premium cap: The total gross exposure related to option premium paid and received should not exceed 20% of the net assets of the scheme, subject to the applicable SEBI framework. 
• Interest-rate swaps Single-counterparty limit: The exposure to any one counterparty in respect of plain-vanilla interest-rate swaps for hedging shall be subject to the applicable SEBI limit.
• Cash-equivalent carve-out: Cash or cash equivalents with residual maturity of less than 91 days may be considered not to give rise to exposure under the applicable framework.

What Mutual Funds Can and Cannot Do

Mutual funds can use derivatives for hedging, portfolio management, arbitrage and other permissible purposes subject to SEBI regulations. SEBI conditions state that mutual funds are generally not allowed to write options unless it is under permitted strategies such as covered calls. Under the provision of covered call, an eligible mutual fund scheme can write call options on the eligible equity shares purchased by the scheme, subject to conditions and limits specified by SEBI.

A covered-call strategy is allowed on eligible equity shares that meet SEBI's prescribed criteria, including those that are constituents of the Nifty 50 or Sensex, subject to applicable limits. The total notional value of call options written by a scheme shall not exceed 15% of the total market value of equity shares held by the scheme. The total number of shares underlying the call options shall not exceed 30% of the unencumbered shares of the particular company held by the scheme. 

When comparing the two approaches, a covered-call scheme earns premium income in exchange for giving up some upside, while a long-only equity scheme retains full upside participation. 

Fund Categories That Use Derivatives Most

Two categories use derivatives as a central feature of their scheme design: arbitrage funds and equity savings schemes. The sub-sections below walk through each in plain terms.

Arbitrage Funds

An arbitrage fund holds paired positions—a long position in the cash market and a matching short position in the futures market on the same stock. The fund captures the small price gap between the two. Because the two positions largely offset each other’s directional exposure, arbitrage funds generally have lower sensitivity to broad market movements. Arbitrage funds seek to reduce directional market risk by exploiting price differences between cash and derivative markets. In a rising market, this approach can limit the upside available compared with a pure equity fund. 

Equity Savings Schemes

An equity savings scheme generally combines equity exposure, equity-related hedged positions, and debt or money-market investments, with the exact allocation varying by scheme. An equity savings scheme generally combines equity exposure, hedged equity positions, and debt or money-market investments. The hedged component can partially offset equity-market movements and help moderate portfolio volatility. 

Risks and Trade-offs of Derivative Exposure in Mutual Funds

Hedging can reduce downside risk, although some hedging strategies may limit upside participation or involve additional costs. Option premiums paid for protection are a cost the fund carries whether the market moves or not. 

The scheme information document states whether the fund uses derivatives for hedging, arbitrage, or covered calls. You can then review the half-yearly portfolio disclosure to see how much of the scheme is allocated to derivatives. If a scheme breaches its exposure limit, then the trustees must report it to SEBI and correct it. 

Conclusion

In India, futures and options are permitted for mutual funds within the SEBI regulatory framework. Fund managers use them to hedge portfolio risk, manage exposure, implement arbitrage strategies, and, where permitted, write covered calls.

As an investor, you need to understand what you are using derivatives for and what risk you are taking. The scheme information document and portfolio disclosures will help you understand the strategy and make an informed decision whether the scheme is suitable for your investment horizon and risk appetite. Derivatives are included in the portfolio, so view them according to the scheme’s overall objective, asset allocation, and risk profile.