e-Nagar

In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Usually they come in 2 flavors Options and Futures.

Take a farmer (the earliest form of hedging): you expect to grow wheat and expect the price to be 800 per quintal with a cost of 600/- for you. Now if the price of wheat after 6 months is 700/- , your profit reduces by half, without any fault of yours. Similarly increase of price to 900 will increase your profit by a third. So:

1) So you take the price fluctuation as an act of god and live with it (or maybe even commit suicide).
2) You fix the price with the grain merchant by having a futures contract with him. So irrespective of the market prices at the time of harvest you will be paid 790/- per quintal. You lose 10/- but it removes the uncertainty from the mind of the farmer. On the other hand the merchant earns an extra 10/- plus he is assured of the grain even if the prices go sky high. So for a small fee, all the uncertainty is transferred to a second party.
3) The farmer might not want to lose on the windfall he might make if the price rises. So he instead of the derivative, he buys an insurance policy (the option contract). This contract gives the farmer a legal option to sell at 800. For the merchant to bite this bullet he pays him a sum upfront say 15/- (which is non returnable). So if the price falls, he sell it to the merchant at 800/- and is shielded from any losses. However if the price of the wheat rises above 815/- he actually makes a profit by selling it to the open market.

Point 2 is an example of futures, while point 3 is an example of options. Together these 2 constitute the derivatives market which is used for hedging your stocks.

Prax recently forwarded me this SEBI circular about ban on entry loads for all Mutual Funds.

Now I agree that it is beneficial for the consumers. But was it a much needed reform? This move will do more harm than good. Here is why:
In spite of the fact that we have very high taxation rates and our savings rate is also amongst the highest in the world, most Indians do not understand financial markets or tax planning. Mutual funds have been valuable learning ground and one of the best stepping stone for these individuals and has helped them to understand how the markets operates and what are returns.
It teaches people how the growth in economy translates into increase in valuations of stock market and how they can tap into it and make money.
The mutual funds disclose their portfolio and hence gives chance to a common man what good companies are and how to pick and choose a company.
the sector funds help us identify the areas where growth is likely to happen
and the debt funds teach us what inflation is and how the interest rates are expected to behave in future.

In gist, in the past 5 years, through mutual funds Indians have been able to channelize their money into stock market and not only benefited from it, but also helped several industries to raise funds, expand their operations and fuel the growth of the nation.
But the real warriors which helped the mutual funds bring in such a revolution were the Agents. They painstakingly sat with each individual, explained them the risks, benefits, the strategies etc and helped the mutual fund market grow to proportions it is today. If the mutual fund industry was not there, then a few thousand Indians and FII would have cornered the entire market kept the entire benefit of the growth in indian economy.

Few years ago, when I had a good entrepreneur idea, a wise man had said:
“Its a good idea and you can help thousand of people with it. But the only problem is that you cannot make money out of it. It is almost impossible to hope that Indians will pay the right price for any service/advise/assistance. They will pay thousands for a piece of equipment, but they want all their software, and advise for free.”

Thats exactly what has happened with the mutual funds. If you want to reform them, reduce the Asset Management Charges (which are the highest in the world), do not starve the poor agents. With one stroke of pen, SEBI killed an entire booming industry

Another reason why I say this step was counterproductive because already there were several funds which charged zero entry/exit load.
1) Exchange Traded Funds
2) Index Funds
3) Liquid funds
4) NFO (the entry load is hidden)
Yet they were not popular and most people are not aware of their existence. Had people be as cautious as the SEBI claims towards the entry load, then we would have seen more and more money flowing towards these funds and this would have put a competitive pressure on the traditional mutual funds to cut costs.

A lot of people still need hand holding, and by killing the financial advisory we have robbed them of their road to riches.