A mutual fund that offers safety

You've got to give it to the fund managers. Just when you think they have exhausted all new innovative ideas, they come up with a new one. Even if it sometimes means just tweaking a bit of the structure here and there to make it look like a brand new proposition.

The new kid on the block is Tata Equity Management Fund (on the same lines as Reliance Equity Fund). While the Reliance one is an open-ended fund, this one is close-ended for the first 18 months and then turns into an open-ended fund.

Here's how the fund will work.

First the fund manager will look at the weighted average Price-Equity ratio of the index - S&P CNX Nifty. Depending on that, he will decide how much of the portfolio must be hedged.

Before we carry on, there are a few terms that you must understand.

Like any fund, the fund manager will invest in stocks in the cash market. This refers to stock market transactions where stocks are traded for delivery. In simplistic terms, where you as a retail investor will buy, hold and sell your stocks.

Conversely, the derivatives market refers to the Futures & Options market.

Hedging is when you reduce your exposure to a loss in the cash market by taking an equal but opposite position in the Futures market.

Going short is when you sell a stock (or a Futures) without owning it at that point. Let's say Infosys is going at Rs 3,000 and you are certain it is going to drop to Rs 2,800. You sell at Rs 3,000 and you buy it later when the price dips. You can also take such positions with the index (Nifty Futures).

Got it?
One goes short when they want to benefit from a stock downturn.
One goes long when they want to benefit from a stock upturn.
But one hedges to minimise the downside risk (risk of the market falling).

Don't other funds do it?

Securities and Exchange Board of India had permitted funds to use derivatives for hedging purposes. However, according to their new directives a few months ago, funds are now even permitted to use derivatives for trading.

So this fund will be employing derivatives not only as a hedge but will be able to take pure long and pure short positions too.

When the fund shorts in the F&O segment, the stocks need not be part of the fund's portfolio. While shorting can be used as a hedging technique as well as a speculative tool, in this case, it could be more speculative because they will also be doing so with stocks that are not part of the portfolio.

How safe is this?

The fund works on the rationale that every ascent and descent in the stock market has potential for returns. And by proactively using Futures and Options, one can benefit from periods of volatility.

The logic is flawless. In volatile markets, funds like this will be able to take advantage of both sides of the movement.

By hedging greater amounts of the portfolio when the valuations are steep, this fund is clearly reducing the risk involved in investing in equity. It lowers the risk of higher valuations.

But the test will lie in the implementation and the bets that the fund manager takes. The fund manager would have to be very accurate in his calls as he stands to incur huge losses if the market does not move in the way he has predicted. For instance, he may be bearish on the market and go short when in actuality the market may rise.

Moreover, the Options market lacks liquidity. The Futures market is very liquid but stocks like L&T, Zee Television, SAIL, and Procter & Gamble are not available in the F&O segment. Though these are just a few, the point is that hedging cannot be done for all stocks in the portfolio (if these do feature in the portfolio).

The fund structure

It starts off as a close-ended fund and after 18 months, automatically turns into an open ended one. So if you want to invest, you can do so during the initial offer period and then only after 18 months, once it is open-ended.

However, there will be exit options every week for those who want to sell off during this time frame.

The fund house says that they have kept it close ended because they want to ensure stability of the portfolio so that the fund manager does not have the burden of a volatile corpus - which could be detrimental to this strategy.

However, by doing this, the fund has shrewdly circumvented the latest regulation from SEBI that prevents the issue costs from being passed on to the consumer.

Open-ended funds could pass on new fund offer expenses to the investor. This was subject to a maximum of 6% of the amount raised during the new fund offer period. This expense was amortised over a maximum period of five years. That means this expense amount is distributed over five years and not charged in the first year itself.

However, as per a recent SEBI guideline, open-ended equity funds can no longer do this. They will have to meet the expenses from the load itself.

But close-ended funds can do so over the life of the fund - in this case, 18 months. In this way, fund can recover some of the costs from the investor.

So, if you decide to exit during this time frame, there will be an exit charge levied (which the fund authorities vehemently say is not an exit load). This charge (not disclosed yet) will decrease as you move more towards the end of 18 months.

The minimum application is Rs 5,000 and the fund offering closes on June 9, 2006.

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