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B. Venkatesh

The problem at present is that portfolio managers do not seem to have a hedging strategy at all.

MUTUAL funds that had HPCL in their portfolio would have been hurt on the day the stock fell 14 per cent due to the Supreme Court judgment on divestment.

This calls to question the hedging strategies by portfolio managers in the country. Should not portfolio managers control short-term fluctuation in net asset values (NAV), without comprising the long-term objectives of the fund?

Short-term volatility

Fund-houses often insist that they pursue long-term objectives, meaning that they are not quite concerned about the short-term declines in the NAVs. But that is not always true, for portfolio managers appear concerned about the short-term performance of their portfolio. The reason is that management fees are a function of the asset size; larger the assets under management, higher the fees.

Now, retail investors are typically short sighted in their investment objectives. A fund that has performed well in the last couple of months is perceived as one that will do just as well in the future.

There have been numerous research papers to suggest this kind of investment behaviour. This means that the fund that has performed well in the near term is more likely to attract higher cash inflows than one that has not.

An average portfolio manager would, hence, tend to invest a proportion of the portfolio in momentum stocks. Such stocks can be defined as those that are expected to move up sharply in the near term. As a logical extension then, the fund should construct appropriate hedging strategy to ensure that the portfolio is not affected in the short-term.

Hedge

A fund may, for instance, choose to hedge only 50 per cent of its total portfolio. Or it may decide to hedge only the stocks that are considered momentum plays. This could entail demarcating the assets into trading and investment portfolio.

The problem at present is that portfolio managers do not seem to have a hedging strategy at all. This can be discerned from the fact that the funds do not have a position in the derivatives market. Note that using value-at-risk models to control risk is not the same as hedging.

Such risk models attempt to control the portfolio risk by managing the exposure in the spot market. Hedging, on the other hand, refers to taking a derivatives position that is contrary to the one in the spot market.

Of course, portfolio managers may take refuge by stating that SEBI's definition of a hedge is unclear. But this argument does not hold much water, because SEBI has clarified that mutual funds are permitted to hedge by taking positions contrary to their exposure in the spot market. Note that the fund-houses cannot also defend themselves by stating that the investment objectives do not provide for such hedging. Most funds that were started way before derivatives trading was introduced in India now have unit-holders' approval to construct a hedging programme.

The question is: What kind of risk needs to be hedged? At the least, portfolio managers should be urged to hedge event risk. This is the risk of the stock declining in value due to a possibility of the occurring of a certain event. In the case of HPCL, it was the Supreme Court ruling on divestment in the company.

Another example would be, say, an upcoming US Federal and Drugs Administration (USFDA) ruling on a pharma company filing for a new drug.

If a mutual fund holds substantial shares of that company's stock, it may have to consider hedging its position against such an event risk. The reason? The stock may have flared up in anticipation of a favourable verdict from the USFDA. What if the ruling is adverse? The stock may tank, as was the case with HPCL.

Prudent portfolio management practice, thus, demands that mutual funds construct a hedging system to curb short-term decline in NAVs. This would emphasise the need to construct the portfolio in the backdrop of a short-term and long-term risk-return matrix.

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