The Hindu Business Line : How about the idea of a fixed-maturity equity fund?

A fixed-maturity equity fund has to actively control its market risk, especially at the horizon. This requires using derivatives. The idea will, therefore, be in the realm of theory, unless SEBI allows mutual funds to invest in derivatives.

ALL MAJOR fund-houses have floated fixed-maturity bond funds. Such a fund allows the unit-holders to achieve their investment objectives through horizon matching. An investor with a five-year horizon can buy units in a fixed maturity bond fund that has a five-year maturity.

This article moots the idea of a fixed-maturity equity fund (FmEF). The concept is the same except that stocks not have a fixed life as bonds do. So, an FmEF has to actively control its market risk, especially at the horizon.

This requires using derivatives. The idea will therefore be in the realm of theory, unless SEBI allows mutual funds to invest in derivatives.

Need for FmEF: A fixed-maturity bond fund immunises horizon risk. This is because the bonds held in the portfolio at the horizon are redeemed with the issuer-companies and are therefore not affected by interest-rate factors or other yield curve risk. Such funds are, however, exposed to inflation risk.

Anari and Kolari* show that stocks could be good long-term hedge against inflation.

Of course, several other papers have documented that equity may not always act as inflation hedge. The important point is that nominal-coupon bonds run high inflation risk. Stocks could moderate this risk.

Moreover, stocks have higher upside potential while bonds are constrained by the pull-to-par phenomenon. It is, therefore, important for investors to have equity as part of their portfolio.

Controlling market risk: Equity does not have fixed maturity. Investors in an FmEF will be, therefore, exposed to high horizon risk. This is the risk that the stocks in the portfolio may decline in value at the horizon, thus, preventing investors from realizing their investment objectives. Typical investment objectives could be funding children's education or buying a house.

Suppose a fund floats an FmEF in 2005 with a ten-year maturity. What if the stock market suffers a 10 per cent drop in 2015? Unit-holders may be unable to achieve their investment objectives unless the fund has enough returns in the earlier years to cushion the market decline in the year of redemption. It therefore follows that the fund is highly vulnerable to market risk through the investment horizon. The important task then for an FmEF's portfolio manager is to control market risk and also beat inflation.

Structured payoffs: A fixed-maturity equity fund would have bonds as a core portfolio to provide stable returns. The portfolio manager will enhance returns through futures, options and swaps. A simple portfolio structure could have 75 per cent in bonds and 25 per cent in stock index futures. The portfolio manager would have to trade with strict protective stops so that losses on index futures do not drag down returns on the bond portfolio.

A more sophisticated portfolio would have bonds and stocks mixed with swaps. The portfolio manager could swap returns from the stock portfolio for a fixed payment from the counter party. Such a fixed-for-floating return swap could have built-in triggers such as minimum returns on the stock portfolio to moderate the moral hazard problem that the counter party may suffer.

The moral hazard problem arises because the professional money manager may be indifferent to the portfolio construction process and earn lower returns on the stock portfolio. The above-mentioned structures are just indicative. Exotic swaps and options can also be designed to control market risk. A fund can, for instance, take a passport option on the stock portfolio.

A passport option is a call option on a trading account. The unit-holders of the fund will reap all the benefits if the portfolio manager generates positive returns on the stock portfolio. And what's more, the option seller will insure losses on that portfolio. This means that the unit-holders are protected against the downside in their stock portfolio and also gain from the upside. Of course, passport options are costly. Using swaps and options to structure payoffs has another cost; such products are not liquid. This necessitates a change in the structure of the FmEF. Such plans cannot be open-end funds. An interval fund would be a compromise while a closed-end structure may be optimal.

* Anari, Ali, and James Kolari, 2001, "Stock prices and Inflation", The Journal of Financial Research, 26, pg 587-601

(Feedback can be sent to bvenky@thehindu.co.in)

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