Close-ended investment solution a good investment option

Remember the question from one of the classic Akbar-Birbal stories: “What is the thing that travels the fastest in the world? Back in the days of Mughal Emperors, travel was typically by bullock carts, horseback etc. In the story, Birbal didn’t come up with any forward looking vision or forecast of the Hyperloop or airplane or bullet train but he had given a very witty response and justified to Akbar, that “The fastest thing in the world is not the horse or wind or light or sound, but it is the mind which can take you from your throne in this court to anywhere else in this world in the next second.”

Moving from childhood stories to the world of investments, many in the world of finance will agree with the view that mind is fast and it is always more volatile than market.

Over the past year, we have seen a common trend across most global markets of low volatility and high liquidity, coupled with a globally synchronised growth in corporate earnings. The result is a strong rally in equities across many developing and developed markets, including India. This rally comes hand in hand with a fear of what is going to happen next – global geopolitical tension, crude shocks and other uncertain events beyond our direct control keep the mind busy thinking :

Will we see increased volatility in the market? Is some potential downside correction likely in the market? 

But even if I worry about all this, I don’t want to be left out of the rally!

Investor behavior suggests that people are more likely to redeem/churn their investment during times of volatility. Often, if this is followed by a rebound, investors find it difficult to re-invest in a rising market.

To take care of the volatile mind, we need an investment solution which can participate in equities, provide a cushion in case of a potential correction and ensure the investment stays put during the investment horizon to avoid any behavioral bias caused by the volatile mind.

These concerns can be addressed quite effectively through a closed ended mutual fund with in-built risk management by way of a put option. While we have all heard of the benefits of close ended funds in general, there is more to this kind of close ended fund in terms of its strategic make-up and its inherent characteristic to lend itself to easier risk management. Here is why:

 Size of the portfolio

The fund manager needs a specific size to hedge the portfolio. In case of an open ended fund, with daily inflows and outflows, it is not feasible to buy a put option to cover the entire fund.

Maturity of Put Option in an Open Ended Fund

There is no specific time period in an open ended fund. Hence the tenure of the put option would remain open ended in nature as well. So if the fund manager buys the near month option contract and then keeps rolling over, then it could result into a higher roll over cost for investors.

Cheap might not always remain cheap

Besides the roll over cost, if say after 6 months, volatility in markets increases, then at that time, the option prices would shoot up as well.

Buying a long dated Put Option

Today, volatility is at multi year lows due to which option pricing is low. Hence it would be expedient to buy long dated 3 year Put Options as it would be available at relatively low prices. It’s better to prepare for volatility when it’s low – Noah’s Ark was built when the weather was sunny and not after the floods had hit.

Maturity of the Put Option aligned with tenure of close ended fund

Once purchased, long dated options can have price fluctuations and lower liquidity on the exchange during the holding period. There are close ended funds with the nature where the maturity of the put option is aligned with the tenure of the fund hence considerably limits concerns of price fluctuations or lack of liquidity. As the options come closer to maturity, there is generally healthy liquidity and alternatively, it can be held till the expiry date to get the requisite payoff.

To conclude

The logic is simple, only if we look at it with an open mind. There is a possibility that at certain times in the market, even a close-ended investment solution can be a good allocation for your portfolio.

Author is Senior Vice President, DSP BlackRock Investment Managers Pvt Ltd

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