How covered call feature can increase mutual fund return

To get handsome returns for investors, mutual fund managers always look for new strategies.
Covered call facility is one such option. In January 2019, the Securities and Exchange Board of India (Sebi) introduced a covered call facility. This strategy has been especially popular in the past year, with many fund houses taking advantage of Sebi’s ruling to offer better returns to investors.

Let’s take a look at how a covered call strategy works:

A covered call strategy involves holding a long position of a stock in cash market and then selling/writing a call option on the same stock to generate income. The fund manager earns a premium to sell the call option. This call is always sold at higher price, and the fund manager holds the stock until that price is reached. Here are 2 things that we need to keep in mind. 1st is that this strategy is used during a bull run in the market and 2nd this strategy is used when fund manager feels that he wont be able to earn enough return in a cash market.

In India, SEBI has allowed fund managers to write the calls only on Nifty 50 / BSE Sensex stocks, and it can’t be more than 30% of the total portfolio holding in the mentioned stocks. The cover strategy helps fund managers in hedging the risk.

Let’s look at its advantages:

1st is that there is downside protection to the extent of the premium collected. 2nd advantage is generating additional returns in the form of option premiums in a range-bound market. If this strategy is used properly then unit holders earn additional return.

Now let’s look at the risks in this strategy:

The writing of the call option would lead to a loss of opportunity due to an appreciation in the value of the underlying equity shares. For example, let us suppose that the price of a share is 100 rupees. The fund manager uses the call option at 110 rupees and sells the share. Afterwards, the share price rises to 125 rupees, so even after the premium, the manager has lost the opportunity to earn good returns.

When markets fall abruptly or a stock hits a lower circuit breaker in a jiffy, the fund manager with covered calls can get stuck on crisis days. Then there can be loss despite the premium.

Amar Ranu, Head – investment products & Advisory, Anand Rathi Shares & Stock Brokers said “Investors have no direct influence over the strategy – it is the fund manager’s discretion if they want to use this option and generate additional returns for unitholders even though it’s minuscule. Right now, many AMCs have been using this with likes of PPFAS, Edelweiss, DSP, etc”

The investors who purchased schemes where the fund managers use a covered call strategy would enjoy the benefits of extra returns that fund managers earns.

So if you are looking to earn extra returns, then you have to keep in mind which scheme of which fund uses covered call strategy.