Mr. Rajeev Thakkar, CIO, on why we have enabled 'Covered Call' Options writing in Parag Parikh Long Term Equity Fund
Please note that investors can access the addendum to the offer document relating to covered call options here.
The following is a simple non technical note and it does not get into aspects of options valuations, various strategies etc.
It is an attempt to address some of the frequently asked questions relating to the addendum that our team has been receiving ever since we released the related Addendum earlier this month.
Frequently Asked Questions
Why are we using derivatives? Would our late founder Mr. Parag Parikh approve of this? How is it compatible with long term investing?
Ever since we launched our flagship Equity Scheme, Parag Parikh Long Term Equity Fund (hereinafter known as “The Scheme”) in 2013, we have incorporated provisions to avail of Derivatives at opportune times.
For instance, our investors would have noticed 'Cash to Futures' Stock Arbitrage positions in our factsheet in the past (even as recently as February 2020).
We have also been using currency futures contracts to hedge our currency exposure.
In other words, we have been utilsing different variants of Derivatives, periodically. We have even used Options based strategies in 2008 and 2009 (during the pre-mutual fund days).
Rest assured that we are not shifting from our core philosophy and approach to money management.
Our stock selection criteria and investment process remains the same as it was.
Why now? Why the addendum?
The provision for writing covered call options was absent in the Regulations when the Scheme was launched. It was permitted via this circular. The permission to mutual funds to pursue this strategy only came on January 16, 2019.
In the month of June 2020, our investment team saw certain unusually high Option prices in the market given the elevated volatility. However since we had not incorporated the provisions in our Offer Document and did not have all clearances in place, we could not avail of those prices. Hence we set in process the change in the offer document and the addendum.
Are Derivatives not risk? Have we not heard of Mr. Warren Buffett calling them Financial Weapons of Mass Destruction?
It is true that Derivatives can be used to speculate, to leverage and to blow up. It is also true that derivatives can be used to hedge and to manage risk. Just like a kitchen knife can be used to stab people and also be used to cut fruits and vegetables, Derivatives can also have multiple uses.
The use of derivatives by Mutual Funds is subject to strict guidelines by SEBI. These among other things prescribe the following.
Derivatives cannot be used to leverage
Derivatives cannot be used to short sell
Derivatives are only to be used for hedged strategies / hedging
In light of changing circumstances and changed Regulations, we periodically change our offer document. This is to have the enabling provisions in place. They may or may not be used immediately. In some cases we hope to never use the enabling provision (case in point creation of a segregated portfolio for our liquid fund).
Some enabling provisions in the past have also been made for investment in REITs and INVITs. This was done last year. We have not yet invested in these instruments as the market is still developing. Hence each enabling provision does not mean a significant change in the way the fund is managed.
A complete list of the various addendums we have issued in the past can be found here.
Will you do this all the time? How significant will be the exposure?
We do not expect to be using this all the time for all our investments. The use of the strategy will be selective and depending on the extent of mis-pricing / opportunity that we see in the options market.
Also at times where the stock cash to futures arbitrage yields are zero to negative, this strategy may provide an alternative mechanism to deploy funds.
The position limits are already mentioned in the addendum and the SEBI circular. However they are given below with some context.
- Covered calls can be written only on Nifty 50 / BSE Sensex stocks. In our portfolio as per the Factsheet of August 2020 these would be
- Axis Bank
- Dr. Reddy’s Labs
- HDFC Bank
- Hero Motocorp
- ICICI Bank
- Sun Pharma
Of the above stocks, we cannot write options on more than 30% of our portfolio holding in the above stocks.
In other words, 70% or more of the holdings in the above stocks will be without any options on them. 100% of our investments in other stocks will be without any options on them.
Total notional value of options cannot exceed 15% of the equity value.
Net net, we believe the overall exposure to the strategy (if at all) will be small.
What exactly is a covered call strategy?
An example is already given in the addendum. I am not attempting a technical definition here. However in any stock, there are three possible outcomes in a defined future period
- The stock price can go up
- The stock price can be flat
- The stock price can go down
In the first case, if the price rise is very sharp, the fund may have an opportunity loss. This is because the fund would have committed to sell at a predefined higher price. However in all the scenarios the fund generates additional income on account of the premium received on the call options.
Chief Investment Officer & Director,
PPFAS Mutual Fund