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Sunday, February 25, 2001













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Index futures as a risk-management tool

B. Venkatesh

IS INDEX futures a risk-management tool for fund managers?

If the question seems innane, let me assure you it is not. The question actually sparked a discussion I had with a leading fund manager some time back. The fund manager's contention was that index futures is not a risk-management tool. In this article, I lay down the arguments set forth by the fund manager and the reasons why I do not quite agree with them.

But, first, how can funds perceivably use index futures? Suppose Fund `X', an equity fund, has a large proportion of its exposure in Hindustan Lever (HLL) and Infosys.

Further, suppose the fund manager feels that HLL may fall in the near-term but also thinks the stock holds good long-term potential. He, thus, has two options to protect the near-term downside in the net asset value (NAV). One, sell HLL and buy the stock at a lower price but that involves large transaction costs. Two, short index futures.

How does shorting index futures help? We know that HLL is a heavyweight in the index. This means the cash index will go down if HLL falls. And index futures typically moves in the same direction as the cash index. Shorting index futures will, thus, help the fund manager protect the downside if the HLL stock price falls. How?

As index futures falls with HLL, the fund manager can close the futures contract at a lower price and profit from the deal. The profit from futures contract may offset the loss suffered by the equity portfolio, provided the fund manager uses an optimal hedge. Now, the fund manager posed the following question: How different is index futures from any stock?

What he asked was essentially this: In the above example, would it make any difference if a fund manager shorts, say, Satyam Computer, instead of index futures?

Of course, at present, mutual funds cannot short sell. But even if SEBI lifts the ban some time soon, such a strategy may not be very effective. This is because the stock to be short-sold has to have a strong correlation with the stock whose downside is to be protected. In the above example, this means Satyam has to move in the same direction as HLL.

But what if the fund manager shorts HLL itself? Actually, what the fund manager will do is technically called ``shorting the box''. This refers to shorting a stock with an intent of buying it back later and all the time holding the stock itself. In this case, the fund manager holds HLL which he does not want to sell, because of its long-term growth potential. Yet, he wants to protect the fund's NAV from a likely fall in the near-term. He, therefore, shorts HLL hoping to buy it back at a later date. In case the price goes up, the fund manager can deliver the stock from the portfolio. Otherwise, he can cover the short-position at a lower price. This is similar to covered call write in the options market. But there is a problem with this strategy.

What if the fund manager expects a couple of stocks to fall in the near-term? It could mean shorting all these stocks to hedge the risk. And that could prove costly as shorting stocks requires maintaining large margins on the trading account with the broker.

Now, shorting index futures in such cases is more effective. As its underlying base is a basket of stocks, index futures can be used as a hedge for a wide range of stocks. Besides, as contracts are marked-to-mark on a daily basis, the counterparty default-risk is lower in the case of futures than with stocks.

The discussion then shifted to whether fund managers needed to hedge at all in the first place. The fund manager felt that funds had no necessity to hedge as they did not a run a risk. The rationale? You run a risk only when there is a likelihood of not being able to meet a target return. Now, equity funds do not assure returns to unit-holders. So, what risk does a fund run? If anything, he argued, it was the unit-holder who needed to hedge his/her risk.

This is an acceptable line of thought. But why should that prevent fund managers from trading in futures? Will the unit-holders not benefit if the fund manager were to trade in index futures?

Consider this. The unit-holders tend to get nervous when their fund's NAV falls. Fund managers can protect NAVs from falling in the near-term by suitably hedging their portfolio through index futures. Besides, outperformance also helps mutual funds attract more money. Research conducted on investor psychology by several behavioral scientists also buttress this point.

Goetzmann and Peles, for instance, conducted a study on mutual fund flows. They found that money moves fast into mutual funds that perform well, than out of funds that perform badly. The study terms this behaviour cognitive dissonance.

Simply put, this refers to the mental conflict that investors experience when their beliefs and expectations go wrong. The unit-holders in the mutual funds that lose money are, therefore, unable to confront their bad investment and, hence, do not sell the fund. By the same logic, investors prefer to invest in funds that are doing well. In the event a fund's performance turns bad, they easily explain the losses because everyone else has also bought the fund.

How is cognitive dissonance related to fund managers using index futures? If a fund manager uses index futures to protect the near-term downside, the fund's performance may be better than its competitors. And the better performance may attract higher inflows.

Of course, I did not quote this study to the fund manager during our discussion. But when I mentioned that index futures can help the fund protect short-term losses, he was quick to point out that unit-holders may not take kindly if the fund manager's view were to go wrong.

For instance, what if a fund manager shorts index futures and the market actually moves up instead of going down? The fund's NAV will suffer because the profit made in HLL (as per the above example) will be lost on covering the index futures at a higher price.

I think the concern voiced by the fund manager is a bit over done. Do unit-holders question the fund manager on why, say, DSQ Software is part of the equity fund's portfolio? Or, do they question the fund manager why he did not sell Infosys when the stock was about Rs 10,000? They do not because they are aware the fund manager is better informed on the market. In other words, the unit-holders are willing to play with the fund manager's view. So, why should it be any different with index futures?

In all, fund managers can use index futures as a risk-management tool to protect their near-term downside. Of course, the basic premise of index futures as a risk-management tool is that the stocks the fund manager wants to hedge have a strong correlation with the index. Otherwise, the fund will run a basis risk. Besides, the fund manager needs to get prior approval from unit-holders to trade in such instruments.


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