The Methodology
The FIB Fund takes short positions in individual stocks and market proxies, and purchases put options, to benefit from a anticipated decline in particular stocks or stock market indices. The fund also holds some "long" positions, primarily stocks of gold and silver asset classes. Investors should realize that the fund is not a "market neutral" fund, but will typically have far more "short" than "long" exposure. And because most long positions are gold stocks, the long portion of the portfolio is unlikely to closely track the general stock market. The fund manager believes this portfolio of short positions and gold stocks will benefit if the long bear market continues to unfold as we expect.
The fund regularly makes short sales of securities, which involves unlimited risk including the possibility that losses may exceed the original amount invested. The fund may also use options and future contracts, which have risks associated with unlimited losses of the underlying holdings due to unanticipated market movements and failure to correctly predict the direction of securities prices, interest rates and currency exchange rates. However, a mutual fund investor's risk is limited to one's amount of investment in a mutual fund. The fund may also hold restricted securities purchased through private placements. Such securities may be difficult to sell without experiencing delays or additional costs.
How does the fund potentially benefit investors in stock market declines?
Like most mutual funds, the Fund is a broadly diversified investment vehicle. But the FIBFund is primarily engaged in "short sales." The fund may also purchase put options. An investor who sells a stock short or buys a put option profits when the stock goes down. The fund also holds short positions on indexes which act as proxies for the stock market or a segment of the market. This portfolio of "short" positions (in addition to put options) allows the fund to potentially benefit from a steep market decline.
The fund does have some long positions, but these are primarily stocks of gold mining companies. We expect gold stocks to benefit during the secular bear market that we believe is ongoing. What is short selling?Typically an investor buys a stock in hopes it will appreciate. He tries to "buy low and sell high." But if you believe the price of a stock will decline you can sell a stock short. Here, the goal is to sell "high" and buy the stock back "low." An investor may short a stock because he believes it is overvalued or because there is fundamental problem with the company. Or an investor may want to protect against a broad market decline by shorting a number of stocks or an index. How do you sell a stock short?When you short a stock you borrow the stock from you broker and sell it in the market hoping to buy at back later at a lower price.
Here's how it works:
Assume you think
XYZ stock will decline in price. You short 100 shares trading at Rs.100 a share. You borrow those shares from your broker who then sells them at the going price and deposits the Rs.10,000 from the sale in your account. Now you owe the broker 100 shares of XYZ regardless of the price of the stock. Now assume the price of XYZ falls to Rs.50. You buy the 100 shares in the market for Rs.5,000 and return the shares to your broker. That leaves you with a profit of Rs.5,000 excluding commissions. If you bought back the stock at a higher price, say Rs.150, you would return the shares to your broker, but you would have lost Rs.5,000:
Who sells stocks short?
Sophisticated investors including hedge funds have long used short sales as an important strategy. Especially during "bear" markets, the flexible strategies of hedge funds allow investors to prosper. A common misconception is that selling short is an ugly or unethical practice, even unpatriotic because the techniques make money when a company fails or disappoints investors.
In reality, short selling has an important role in financial and commodity markets, the most important of which is to help keep the markets efficient. Some academics have suggested that informed investors who execute short sales help set the upper limit and keep equity markets efficient. Additionally, short selling reduces the risk of manipulation, and provides liquidity. Some sophisticated investors do not invest in markets that do not have short sellers, because they consider them to be less efficient markets.
Their absence tends to let the markets become too highly valued and therefore too prone to crash. The absence of short selling increases the market's volatility.What is a put option?A put option is the right to sell a stock at a certain price sometime in the future. An investor who buys a put option pays a price (or premium) for that right with the expectation the stock price will decline. How does a put option work?
Say an investor thinks XYZ Corp., now trading at Rs.50, will fall in price. Let's assume the investor buys a put option in the open market for Rs.2 that lets the investor sell the stock at Rs.50 anytime over the next 90 days. If the stock falls to Rs.40 within that 90 day period, the option would be worth at least Rs.10.* So why buy puts instead of shorting stock?
In the above example, the investor would have made Rs.10, or a 20% return, by shorting the stock (Sell at Rs.50, buy back at Rs.40.). The option investor would have made at least Rs.8 (buy at Rs.2, sell at Rs.10), a return of four times the investment.What happens if the stock price goes up?
The value of the option will decline, and will eventually be worthless if not sold before expiration.
If the option was selling for only Rs.4, for example, an investor could buy the stock for Rs.40, then buy the put option, and immediately "exercise" the option by selling the stock for Rs.50, making a risk free Rs.6.
Srinivasan Venkataraghavan is Chief Executive Officer, Altos Advisory Services.
