Making sense of MFs’ covered call strategy

8 min read . Updated: 05 Sep 2022, 11:27 PM IST

The strategy is to earn additional income but this won’t affect scheme’s style of investing, portfolio.

It was in January 2019 that the Securities and Exchange Board of India (Sebi) allowed mutual funds to write call options under a covered call strategy. Ever since, especially, in the past one year, many fund houses — such as PPFAS, DSP, Edelweiss, SBI and Aditya Birla Sun Life mutual fund — have been either enabling or implementing covered call strategy in a few of their schemes.

A covered call is an options strategy in which the person writes (sells) a call option on the stock that is already held in the portfolio. The call option sellers (fund houses here) can generate income in the form of option premium, which is paid by the option buyer.

“It is true that derivatives can be used to speculate, to leverage and to blow up. However, it is also true that derivatives can be used to hedge and to manage risk. Just like a kitchen knife can be used to stab people and also be used to cut fruits and vegetables, derivatives can also have multiple uses," wrote Rajeev Thakkar, CIO, PPFAS Mutual Fund, in a communication to investors when the fund house enabled the covered call strategy in October 2020

The increased interest amongthe fund houses in the covered call option in the last one year is because this strategy allows fund managers to generate additional income, especially, in a falling or sidewise market. The latter refers to a phenomenon where the stock market shows no clear trends and is typically volatile.

To put the covered call options trend in perspective, in June 2022, when the market was still witnessing sell-off pressure, PPFAS Flexi Cap Fund entered into 3,437 covered call contracts which generated gains of ₹2.45 crore in that month. This is against just nine contracts that it had entered in May 2021, generating a net profit of only ₹35,291.

“The higher the volatility, the larger the benefit of covered calls," said Feroze Azeez, deputy CEO, Anand Rathi Wealth.

Though the gain made by the PPFAS fund house in June 2022 was minuscule compared to its assets under management (AUM) of about ₹22,300 crore in that month, the fund house believes that it will add a bit to the fund’s yield in the long run. This view has also been echoed by DSP Mutual Fund, which has been using the covered call strategy in its Quant Fund, of late.

“We haven’t even reached close to the permissible limit for covered calls in our flexi-cap fund. Further, the idea of using the strategy is not to generate material gains, but to generate some additional returns which otherwise wouldn’t have come to us," said Raunak Onkar, research head & co-fund manager at PPFAS MF.

Also, it is important to remember that the use of a covered call strategy by the fund houses will not change a scheme’s fundamental style of investing and building the portfolio.

How it works

When a fund manager expects the price of any stock in the portfolio to fall or remain sideways in the short run, writing a call option helps in making additional returns while continuing to hold the stock.

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For example, say Reliance Industries Ltd (RIL) is part of a scheme’s portfolio bought at the current market price of ₹2,527. The fund manager believes that the stock will not see any significant uptrend in the short run and writes (sells) a monthly call option at a strike price of ₹2,900.

The call option buyer gets the ‘right’ to buy the share at ₹2,900 on the expiry date whatever be the market price on that day. The option buyer pays some amount — an option premium of ₹5.5 per share— to the fund manager for the ‘right’.

Let’s see what the gain or loss the mutual fund scheme makes in different market scenarios.

Scenario 1: When the market price on the expiry day is less than or equal to ₹2,900

The call option will not be exercised and the option premium of ₹ 5.5 per share is the additional return for the fund. The fund manager continues to hold the shares of RIL; call options get exercised only when the market price is more than the strike price.

Scenario 2: When the market price on the expiry day is more than ₹2,900. Let’s put it at ₹3,000 .

In this case, the call option gets exercised – the fund manager has to sell the share at ₹2,900 to the option buyer. The actual profit or loss to the scheme on sale is (sale price minus the cost price plus the option premium received) equals ₹378.5 ( ₹2,900 – ₹2,527 + ₹5.5).

There’s an opportunity loss in scenario 2 for the scheme— had the fund manager not entered into a covered call strategy, the share could be sold for ₹3,000 in the market, which results in a capital gain of ₹473 ( ₹3,000 – ₹2,527). The difference of ₹94.5 ( ₹473 – ₹378.5) is the opportunity loss for the fund.

This happened in July with PPFAS’s Flexi Cap fund, wherein some Coal India shares that the scheme owned were sold as part of the covered call (although at a profit to the purchase price).

Mitigating risks

One of the big risks with the covered call strategy is that it limits the investor’s ability to capture the potential upside of the stock.

In the above example, any price appreciation of RIL shares beyond the strike price is an opportunity loss to the fund manager. However, experts believe that the regulatory measure could limit unusual losses from the strategy.

According to market regulator Sebi, covered calls can be written only on Nifty 50/BSE Sensex stocks. Further, a fund manager cannot write options on more than 30% of shares of any company held in the portfolio. Besides, the total notional value (strike price as well as premium value) of call options written by a scheme shall not exceed 15% of the market value of equity in that scheme.

Fund houses say there are internal measures as well that they comply with to reduce the risk of taking covered calls.

According to DSP Mutual Fund, “to reduce the risk of covered call strategies, we will write covered calls only where the strike price is about 5-10% above the current stock price (with the belief that 5-10% uptrend for an already over-valued stock is unlikely in the short run, which will be favourable to a fund manager’s call.)."

The fund house also highlighted in its communication on the covered call strategy that it will write calls with a near-month expiry and not long-dated options as the uncertainty increases with further future calls. “We also avoid writing covered calls in the face of overall macro uncertainty such as elections where outcomes are not predictable."

Onkar from PPFAS Mutual Fund said, “we will never sell a covered call where the strike price is lower than our purchase price." In our example, ₹2,527 is the purchase price for Reliance; as per PPFAS, the strike price of covered call will be always more than ₹2,527. This is because, even if the call goes wrong and shares have to be sold, the transaction will not lead to actual capital loss.

The fund house also said that it tries to square off the position before the expiry date, if it thinks the covered call is not working in its favour.

Meaningful impact?

“This strategy surely helps in generating additional income, but it will be meaningful only if the scheme is able to write calls on large holdings of the portfolio," said Kirtan Shah, founder and CEO, Credence Wealth Advisors.

As shown in the table, the gains made by PPFAS mutual fund, as disclosed by the fund house, is minuscule compared to its AUM. Also, in the example, as highlighted in the table, in a hypothetical scenario of covered calls going right almost all the time, the additional income contributes just 0.8% per annum to the total value of the fund.

Note, this is just an example and it could widely differ based on the premium amount which is dependent on various factors such as strike price, the time period until the expiry date, volatility, corporate actions and earnings, and expectations of the sector.

On the other hand, if the call goes wrong, the opportunity cost could be higher for the scheme. “I’ve been doing call writing for quite some time. We might be able to make money 11 out of 12 times, but that one time that the stock moves up, it probably might take away a very large share of what you otherwise would have made by holding on to the stock," added Shah.

Most of the distributors and investment advisors Mint spoke to say that they have not been considering covered call strategy as a factor in analysing the fund, as there is no material impact of such strategies on fund returns.

“In terms of a covered call, a retail investor must largely see whether there is a transparent communication from the fund house on its usage than evaluating the nitty-gritty of covered calls taken by the fund manager," added Shah.

Yet, there seems to be no uniformity among fund houses in terms of disclosures on covered calls entered during a month. PPFAS Mutual Fund has been providing detailed disclosure (as shown in the table) among all we checked and communicated it to investors when the calls went wrong (for example, the call on Coal India).

One needs to check ‘detailed portfolio disclosures’ or fact-sheets to obtain details on the covered calls entered into by the scheme, apart from direct communication from the fund house.

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