Active fund managers, after finalising the investment choices, face the biggest risk in the form of market fluctuations. Index derivatives are one of the most important new tools that are helping the fund managers across the world for the last two decades.

Suppose a fund manager has view about whether the index is going to rise or fall, and wishes to take a position on the index in order to profit from it.If he wishes to be long on index, he buys index futures; conversely, if he wishes to be short the index he sells index futures.

Further, he can even use index options to hedge against market fluctuations. Options are useful instruments which can put a clear one-sided cap on the returns to a position. So, if the fund manager wishes to be long the index, he can buy call options or sell put options, if short the index, he can buy put options or sell call options.

Changes in fund policies: Consider a fund like UTI's US-64 which decides to change the character of its investments by greatly reducing its equity exposure.

There are two ways to achieve this without using index futures. One sell off equity in a very short period, but the price obtained on the distress selling would be quite poor.

Two, gradually sell off equity over a period of many months. the avoids distress selling, but implies that the fund must stay at an uncomfortably high level of equity exposure for the period over which this is being done.

Once index futures become available, a third option becomes available. The In the first step, the moment the decision to change the character of US-64 is taken, UTI will short index futures, this would serve to immediately transform the equity exposure of the fund as desired. Worldwide the liquidity of the index future s market is much higher than that of the underlying cash market, so an immediate sale on the index futures market would cost a lot less impact cost than an immediate sale on the equity market.

Two, in the following months, UTI will gradually sell off the underlying equity, and keep scaling down the index futures position commensurately.This approach combines the best of both worlds: the poor execution associated with distress sales of equity is avoided, and the uncomfortably high level of equity exposure for the months over which the equity is gradually sold off is also avoided.

Arbitrage to obtain excess returns: A fund manager having a core portfolio of equities wishes to engage is riskless arbitrage in obtaining excess returns.

Conventional options offer physical arbitrage between NSE, BSE and CSE. Also, arbitrating between NSE's physical trading and depository trading is also feasible, but these avenues are constrained by virtue of being highly competitive.

A third option is to use index futures which the fund managers can use to exploit arbitrage opportunities by virtue of their ownership of the underlying stock, and through their control of large liquid funds.One kind of arbitrage comes into play when the index futures are ``too cheap'' as compared with the fair value. This would involve buying futures, and selling all the fifty underlying stocks (this is something that mutuals can easily prepare themselves to do).At the expiration date of the futures, the fund would buy back the 50 underlying stocks and sell off the futures. This sequence of trades would earn the fund a riskless profit. Absent stock-lending, this is the only way to get revenue out of an investory of paper. This style of arbitrage is feasible for mutuals, but is difficult for other market participants in absence of stock-lending.

Among other uses of index futures are for offering guaranteed returns, settlement procedures, delinking of stock selection from equity exposure, implementation of views at a security level and for balancing resources moving into mutual fund schemes.

However, it is necessary that the fund manager never misses the fact that liquidity is the essential appeal of the index futures market. If liquidity were not an issue, then there isn't anything particularly different about trading 50 stocks versus trading the index. This does not mean that selling on the futures market can be done without any impact on the cash market; the two markets can never be divorced of each other. But the only benefit of trading on the futures market is that it is more liquid and is better able to absorb shocks.

(Extracted from "The future of fund management in India 1977", edited by Tushar Waghmare)

The author is a visiting research associate at Indira Gandhi Institute of Development Research

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.