These mutual funds are turning cautious despite market's amazing bull run

The Indian market is bubbling over with excitement, and almost every company and investor is dancing their way to the bank. Yet, there's a category of funds that has been taking a more measured approach: Balanced Advantage Funds (BAFs). These hybrid funds are designed to adjust their asset allocation as per market conditions, offering protection from significant downturns.

The most recent examples of their resilience could be seen in June and July. On the day of the Lok Sabha election result in June, the broader equity market (Nifty 500) tripped 6.8 per cent against BAFs' just 3.8 per cent. Similarly, in July, the market went off the boil due to the Japan Yen carry incident, falling more than double that of the average BAF.

So, how do the BAFs fall less? Broadly speaking, they use two strategies to pull the handbrakes during a falling market.

Flexibility
BAFs adjust their exposure to equity and debt based on market valuations, interest rates and other macroeconomic factors. For instance, when the equity market is riding high and stock valuations are stretched, BAFs may reduce their exposure here and increase their allocation to debt or derivatives. The opposite is true, too. When the market is low, they may turn their attention back to equity.

You must not confuse BAFs with aggressive hybrid funds, though. While some BAFs do behave like aggressive hybrids by maintaining an equity allocation above 65 per cent for tax efficiency, they can be more defensive than them.

Hedging
One of the key reasons BAFs weather market storms better is their extensive use of hedging strategies. While other hybrid funds might reduce equity and increase debt to protect their portfolio, BAFs have another ace up their sleeve. They hedge a significant portion of their equity holdings using derivatives. This approach provides two main benefits: it protects against downside risks during market volatility and offers a tax advantage by maintaining higher equity exposure.

Turning cautious

Remember we said at the outset that BAFs have not been swept by the market mania? That's right. About half of them have, in fact, substantially reduced their net equity allocation over the past seven months. At a broader level, their median net equity allocation is around 59 per cent, down from 61 per cent in December 2023. While this reduction might not seem dramatic, it signals that BAFs are doubling down on their cautious stance.

At an individual level, Quant and Nippon's BAFs have pared their high equity exposure, while SBI and DSP have gone ultra-defensive. However, it's important to note that DSP has a history of wide fluctuations in its equity allocation.

The last word

Since BAFs have cushioned the downside recently and can be viewed as bellwether funds, we suggest you consider a fund that avoids extreme positions.

That said, we at Value Research prefer funds with static allocations, like aggressive hybrids or conservative hybrids, because they provide greater visibility and predictability. Moreover, unlike BAFs, static allocation funds eliminate the risk of accurately forecasting market movements, whether model-driven or based on human judgement.

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