Tackling market volatility while getting returns

The Association of Mutual Funds in India (AMFI) data for August showed that inflows into equity mutual funds declined month-on-month and were the lowest in the last 10 months, indicating that investors were not convinced with the recent run-up in stock markets.

The data also showed that there was a sharp increase in inflows into debt funds as investors were optimistic about getting good returns on the back of a hike in repo rates. Since June, Nifty has gone up steeply by 12 per cent and valuations have been looking pricey at the PE ratio (price to earnings) of 22.

Investors may be wondering whether there are funds that can manage the volatility of markets and contain the downside risk while at the same time capturing the gains when the market moves up. The answer is yes and they are called Balanced Advantage Funds (BAF).

They have caught the fancy of investors in recent years and were the third most popular investment products among equity schemes after large-cap funds & Flexi cap funds with Assets Under Management or AUM of Rs 1.91 lakh crores. Many fund houses have launched these schemes in the recent past, and financial planners are recommending these schemes to first-time investors or to investors having a moderate risk appetite.

But what are balanced advantage funds and how are they different from plain equity funds? Here’s a lowdown on BAFs:

What are Balanced advantage funds?

BAFs, also called dynamic asset allocation funds, are hybrid funds that invest in a mix of equity and debt asset classes. The asset allocation (between equity and debt portion in the portfolio) of balanced advantage funds is managed by the fund manager dynamically based on market conditions. Also, the asset allocation is determined by the dynamic asset allocation model used by the fund. Typically, a BAF allocates its funds as follows:

Net or unhedged equity: This is the unhedged equity exposure of the fund. Net equity allocation could be around 30 per cent of the assets. The investor is exposed to market risk in this portion.

Debt: Debt or fixed income allocation is usually capped at 35 per cent of the total assets of the scheme are invested in bonds, debentures, G-secs, commercial papers et cetera. The investor is exposed to credit risk and interest rate risk in this segment.

Hedging: A part of the equity exposure of the fund is hedged using derivatives (futures and options). For example, if a fund has 10 stocks/shares in the hedged portfolio it might sell the futures of these stocks in the futures market or could buy put options in the Options market. If the market falls (spot or cash segment) due to events like the Ukraine war or the outbreak of the Covid-19 pandemic, the price or NAV of the hedged portfolio falls but the fund makes gains in the Futures and Options, and it will have zero impact on the NAV.

On the other hand, if the market goes up, the market price of the stocks in the hedged portfolio rises & its NAV goes up, but the scheme will incur losses in the F & O position – the net impact on NAV will again be zero. The hedged equity component will not have market risks. Hedging reduces the net equity exposure of the fund.

How do BAFs generate returns?

BAFs use quantitative dynamic asset allocation models to adjust their asset allocation depending on market conditions. Most balanced advantage funds use counter-cyclical dynamic asset allocation models. Counter-cyclical dynamic asset allocation models reduce allocation to equity and increase allocation to debt and or hedging allocation if equity valuations are high. Funds use metrics like the price to equity or PE ratio or price to book value or PBV ratio for asset allocation. If the PE ratio of the Nifty or Sensex falls below a certain level, then the model increases allocation to equity and decreases allocation to debt.

Benefits of investing in BAFs

Since the combined hedged and unhedged portion of the equity is a minimum of 65 per cent, and the debt portion is capped at 35 per cent, BAFs are treated as equity funds from the taxation point of view which means short-term capital gains are taxed at 15 per cent and long-term capital gains are taxed at 10 per cent on gains above Rs 1,00,000.

If you are looking at stability of returns but want a higher return than debt or a balanced fund, then BAFs make a good choice.

(The writer is a CFA and former banker who currently teaches at Manipal Academy of Higher Education, Bengaluru)