BlackRock Energy & Resources Trust, a $400 million fund in the US defines Covered Call as “Making More by Losing Less”.

Covered Call strategy uses derivatives extensively to hedge and create monthly alpha, but ironically derivatives are defined by a conservative investor as, “weapons of mass destruction”.

We feel use of derivatives is a double edged sword and it is these very derivatives if used smartly, with proper knowledge and systems, can greatly reduce the risk  in the portfolio, while creating alpha too!

Covered call strategy is a conservative strategy for Equity enthusiasts looking for higher returns from the Equity markets, albeit with lower risk. 

Fixed Deposits vs Equity Markets

“Can we get more returns with lesser risk?” is a conundrum for investors rarely answered by the experts. Various asset classes like Fixed Deposits, Debt, Property, Gold, and Equity have different risks associated with them. In these investment options, Fixed Deposits & Equity investments are on the opposite sides of the spectrum. Fixed deposits being most safe, and Equity being most risky. 

Equity is something that creates the maximum wealth in the long run even though it is classified as high risk.

Wealth Creation vs Wealth Destruction

A post tax return from a 1 crore FD yielding 7% over a 25 year period will yield Rs 3.31 crores post tax, compared to cost of living increase due to inflation of 7% during the same period at Rs 5.43 crores. Even though FDs seem extremely safe for the short term, they will destroy almost 40% wealth over a generation! 

So are FDs a weapon of mass destruction? Yes, in the long run they destroy huge hard earned wealth.

Is it a fund manager’s job to educate the investor on wealth creation? Maybe not. But it is definitely his job to ensure maximum returns with lower risk and create wealth in the long run. By using the right tools one can create wealth and not merely preserve it. 

Derivatives – A double edged sword

If Equity is High Risk, Derivatives or Future and Options are classified as Speculative.

Derivatives (Futures & Options) are largely used for speculation across the world. Indian derivative markets boasts of volumes 3 times that in the US, even though we are just 1/10th the size of US capital markets. This highlights how inclined Indians are towards speculation. Covered Call Strategy primarily uses derivatives not to speculate but hedge and call option writing to create monthly alpha.

Equity Mutual Funds

Mutual Funds are the most popular vehicle to invest in Equity markets in India. Mutual Funds have returns similar to the market returns, and the co-relation to the stock market returns is very very high. If the markets are up, the Mutual Funds give good returns, and if the markets are negative during an adverse sentiment, the mutual fund’s performance is also similar.

Mutual Funds in India are at a disadvantage during adverse market conditions as the rules stipulate that equity mutual funds must invest at least 65% of assets in equity at all times.

Within Equity Mutual Funds there are different segments which behave differently during different periods – small caps, mid-caps, large caps, index investing, sectoral bets each have different risks associated with them during different cycles of the economy.

Thus it is very important to understand not just the aspect of returns, but also the risk assumed by each asset class.

Sharpe Ratio for measuring Risk, Reward, & Return

It is normally said that risk and reward remain hand in hand. Also the world believes volatility is same as risk. We do not totally agree with this belief. Here I wish to quote Michael Price, a fund manager in the US, who says, “The Goal is to make good returns with less risk. Risk is not the same as volatility. It’s very hard to measure risk.”
 A good fund manager is focused on returns, but a great fund manager will maximise returns while reducing risk.

Different asset classes have different returns and different risk attached to them. Sharpe Ratio is a measure used to evaluate the risk-adjusted return of an investment or a trading strategy. It was developed by Nobel laureate William F. Sharpe and helps investors understand the return of an investment in relation to its risk. A Sharpe Ratio above 3 is considered quite high and generally signifies that the investment or strategy has produced a very attractive risk-adjusted return. It indicates that the investment has provided a significantly higher return for the amount of risk taken compared to a risk-free investments (like Treasury bills). 

Covered Call writing Strategy 

A strategy gaining popularity in India is Covered Call strategy which we define as “Best of Both Worlds” and Blackrock defines as “Making more by losing less”. This strategy uses Equity which gives stability to the portfolio, and Futures selling for risk reduction to hedge and options writing for generating monthly returns. 

Volvin Limited has launched Volvin Growth Fund – Active Rabbit is India’s 1st Fund in the AIF Category 3 focused on unique strategy of covered call options writing. It targets creating monthly alpha for its investors through aggressive call writing. It has a unique strategy of investing in stocks & creating a portfolio similar to a mutual fund on one hand, and on the other hand delivering returns every month through the derivatives segment by using complex strategies. At Volvin Growth Fund, we have found covered call writing strategy as an effective tool to not just reduce the volatility in the portfolio, but also enhance portfolio returns by selling covered call options on the underlying portfolio.

7 Key features for Volvin Growth Fund – Active Rabbit

  • Covered call option writing is the only strategy that creates alpha even in stagnant or uncertain markets.
  • Best of both worlds – Stability from Equity and Returns from Derivatives
  • Monthly income in the Derivatives segment by call option writing. The fund writes the call options on the underlying portfolio, the premiums for which range from 1.5% – 4.0% a month, which translates into annual premiums of 18-48%.
  • Extremely diversified portfolio of 40-60 stocks at all times, ensures high stability and lowering of risk than most Equity Mutual funds 
  • Uses derivatives for hedging, especially during high volatility in uncertain market
  • Active Management on the derivatives segment used for profit booking & monthly returns generation
  • Maintains an average long position of around 70% ensuring lower risk

All the above features ensure lower CAPM Beta, lower Std Deviation and higher Sharpe Ratio, hence Higher Risk adjusted Returns. Volvin Growth Fund by scoring higher in Sharpe Ratio to most Equity Mutual Funds in the country is poised to usher in a new era where investors will realise that Derivatives is not just speculation but can actually Make More by losing less.

OPTIONAL

Steps in portfolio creation

Stock selection: The domain for stock selection is only the 184 stocks available in the NSE Futures & Options segment. Fundamental analysis is used to identify stocks which can be part of the portfolio. Primary parameters used are PE ratios, Growth of the company & sector, Price to Book, dividend & growth consistency, management, the future outlook for the sector.

Portfolio Creation: Technical charting is used to identify the right point to invest in the stock. Market Structure and technical indicators such as Moving Averages, RSI & MACD are used to identify the entry point. When the identified stock approaches the entry, the entry is made in staggered manner of the total planned investment.

Writing Call options: Monthly Call options on the stocks are sold/ written to generate returns in the derivatives segment. These options are primarily sold on the underlying portfolio in the Equity segment. Whether a call option is sold at the money, deep in the money, out of money is dependent on the technical view of the particular scrip. Staggered selling of call options is also used when the technical view is not clear.

Profit Booking: When the portfolio stock prices reach the target price, the profit is booked in the Derivatives segment by selling the future, still maintaining the cash position in the Equity segment (EQ). Also, when the stock price goes above the call, the call is covered and Future is shorted to book the profits, still maintaining the position in EQ.

Rebalancing: As the portfolio faces continuous profit booking whenever the market or the stock price moves up, the long position keeps on getting reduced as and when the market moves up. The fund also uses the Derivatives segment to buy Futures of the stock identified and writes call options on that. Profits are booked byexiting the total position in this case by covering the call and selling (squaring off) the future. Monthly rebalancing is done to maintain a net long position of 50-100%.

Pros and Cons of Cat 3 AIFs over Equity Mutual Funds

Equity Mutual Funds have daily liquidity, but have to invest minimum 60% of the portfolio in Equity at all times. Cat3 AIFs have no such limit. Also minimum investment in Mutual Funds is Rs 500 compared to Rs 1,00,00,000 for Cat3AIFs. Maximum hedging or call writing allowed for mutual funds is 15%, whereas Cat3 AIFs have a limit of 200%. Volvin Growth Fund has taxation of LTCG and STCG on the equity portfolio similar to MFs, where as it is 39% taxation on the Derivatives and Dividend income.