The Hindu Business Line : Time to introduce inverse funds

SEBI is likely to remove the constraint on short-selling soon. This article suggests that it is the right time for the mutual fund industry to introduce inverse funds. These are funds that move in the opposite direction to the benchmark index. Such funds will help generate alpha returns on the downside
as well as provide optimal hedging solutions for
non-institutional investors.

B. Venkatesh

SEBI proposes to allow short-selling in the stock market. It is, indeed, ironical that short-selling constraint is likely to be removed just after equity prices have tanked. Irony apart, allowing short-selling is a good move that will improve the market microstructure.

We are, however, not going to extol the virtues of short-selling here. Instead, we will show that allowing short-selling provides fertile ground for fund-houses to introduce inverse funds. We believe that there will be good demand for such funds, as they provide optimal investment solutions to non-institutional investors.

Market microstructure

The study on market microstructure focuses on how specific trading mechanisms affect asset price formations. Removing the short-selling constraint alters the trading mechanism and, hence, changes asset price behaviour.

Until now, the market had an upward bias. If demand for a stock was overwhelming, its price climbed up, braked only by the circuit filter. Those who held a negative view on the stock could at best sell their holdings. If demand for the stock was more than the supply, the price continued to gallop upwards. Importantly, investors who did not hold the stock could not act to take advantage of their negative view.

Introducing short-selling alters this equation. Investors who suspect the sharp upmove can short-sell the stock. Large institutional investors’ short-selling a stock can balance the demand-supply equation. And that could moderate the speed of the stock moving up.

Psychology of short-selling

As humans, we prefer exit options. Knowing that we can short-sell is itself a comforting factor. We may not take advantage of the process, however, as we are hard-wired optimists.

Moreover, most non-institutional investors may not be comfortable with short-selling. The reason is to do with what psychologists call as “Regret Aversion”. It refers to the fear of experiencing the pain of regret. And that fear can prevent us from taking optimal decisions.

Suppose an investor has a positive view on SBI. She will buy the stock and hold it till her price objective is met even if the stock goes down or even if she has to wait for one year. Suppose the investor has instead a negative view on SBI. What if the price goes up immediately after she shorts the stock? She has to buy the stock at a higher price to deliver to the stock lender.

In a buy-sell strategy, the investor has unrealized losses if the stock goes down after taking exposure. In the sell-buy strategy, the investor suffers real losses as she may be forced to close the transaction in the short term. Moreover, upside risk in a sell-buy strategy is unlimited, as the stock price can theoretically go up to any price. Short-selling may, hence, not come that easy for all investors- a reason why the mutual fund industry should introduce a new genre of funds.

Inverse Funds

These are mutual funds that move in the opposite direction to that of the market. The NAV of an Inverse Nifty Fund would go up approximately 10 per cent if the Nifty index declines 10 per cent. Importantly, the investor is long on the short side! That is, she buys an inverse fund to short the market. This helps overcome the behavioural bias mentioned above.

Inverse funds use options and futures to structure their payoffs. An Inverse Nifty Fund will short-sell Nifty futures and would engage in futures-roll.

We believe that allowing short-selling in the spot market provides scope for more active management. For one, portfolio managers can generate alpha returns if they have a negative view on an individual stock. For another, short-selling does not involve leverage as in the case of futures. This is an important factor now given the fear for high leverage after the recent market crash.

Of course, short-selling has its costs- the fund has to pay a fee to the stock lender. We believe that inverse funds would borrow stocks from their family of long-only funds. This will minimize risk of short-squeeze- risk that the short-seller will have to pay a high fee to borrow the stock.

Discerning investors can construct hedge-fund-like strategies using inverse funds. A retail investor can take exposure to large-cap active fund and Inverse Nifty fund. The residual exposure will be to those stocks which do not constitute the Nifty- stocks on which the large-cap active manager has a positive view. This will be similar to the long-short strategy that most hedge funds follow.

Inverse funds will also help in providing optimal hedging solutions to retail investors. Suppose a person’s investment horizon is March 2009. She can buy inverse funds to hedge her portfolio’s downside risk. It is simpler than buying puts and less risky than shorting futures. Given the advantages, we hope that fund-houses introduce such funds soon.

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

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