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Balancing Act

Equity-oriented Hybrid funds let you enjoy the benefits of equity with a dose of debt to hedge on

A balanced approach
I am looking for some equity oriented funds that provide decent returns and minimize volatility. Can you suggest some mutual funds that try to manage volatility by various hedging mechanisms? Would balanced funds provide that kind of stability?
- Santosh Kumar Sahu

If you are looking for equity oriented funds that provide decent returns and minimize volatility, then opting for an equity-oriented balanced fund would be a very smart move. Such funds offer a neat package: Tax efficiency, automatic rebalancing between two asset classes and growth with stability.

An equity oriented balanced fund is one that invests in two asset classes - equity and debt, with at least 65 per cent in equity. Such funds are simplicity at its best. You get a ready-made portfolio that allocates between two asset classes. While the actual allocation depends on the fund manager's call on the state of the markets, he is restricted by the mandated equity allocation. So you won't find these funds going 95 per cent into equity, they will operate within the stated band. For instance, just before the market crashed in January 2008, these (equity oriented balanced) funds held 74 per cent of their portfolio in equity (December 2007). By February 2009, it stood at 63 per cent but moved up to 71 per cent (May 2009) as the stock market began to rally.

The higher debt exposure does tend to hit returns. This category of funds delivered 61 per cent in 2009 as compared to 84 per cent, the average of equity diversified funds. However, this is precisely what you should expect from such funds. They are a more tamed version of pure equity plays. The debt component makes these funds less volatile providing better downside protection and adding to their stability. In 2008, this category of funds shed just 43 per cent against a 56 per cent fall experienced by equity diversified funds.

From a tax point of view, these funds are treated as equity funds. If you had to invest in an equity fund and a debt fund, the latter would face a different tax implication. However, by combining both asset classes, you are benefitting by the equity treatment. These funds even score on tax efficiency.

Going back to your query, you mentioned a hedging mechanism. Equity oriented balanced funds do not employ such strategies but arbitrage funds do. Please note, the two types of funds (arbitrage and balanced) are quite different. Going by your drift, you want to invest in equity but cautiously. Then go for a balanced fund.

Arbitrage funds also invest in both asset classes, with a thrust on equity. In March 2009, this category had an average of 32 per cent of its assets in debt. By July 2010, it was down to 24 per cent. These funds aim to capitalize on the opportunities arising from a pricing mismatch between the spot (cash segment) and derivatives (Futures & Options) market. So higher the volatility, more are the chances of mispricing of securities.

Theoretically speaking, this strategy to profit from the difference between the prices of a stock in different markets makes them immune to upswings and downswings of the stock market. And consequently, are less risky than regular pure equity funds. Arbitrage funds are suitable for risk-averse investors as they are the least volatile in comparison to all other types of funds.

But do note, the returns in arbitrage funds are a far cry from what you would get from an equity fund or even a balanced fund. In 2009, the average returns of arbitrage funds was a paltry 4.26 per cent, far less than that of the NSE Treasury Bills Index (6.08%), a gauge of the performance of the money market. The best performer returned 6.60 per cent.

For a long time, the returns of arbitrage funds have closely followed the returns of liquid funds. But this has not been the case in the recent past, when they have even lagged behind the returns of this category.

Such returns certainly don't make for a compelling case. Unless you are a very conservative investor, we suggest you avoid arbitrage funds.

    Returns (%)  
Category of funds  2008  2009  YTD*
Arbitrage 8.59 4.26 3.56
Equity-oriented Balanced -43.25 60.88 15.33
Equity Diversified -55.58 84.37 19.62
*October 18, 2010

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