How to hedge your mutual fund portfolio

How do I hedge my portfolio of mutual funds? When the market rises, investors typically stay invested rather than selling off their holdings, but a market downturn can cause concern. What can be done to protect long-term investments? - Anonymous

Hedging a mutual fund portfolio isn't straightforward. When the equity market declines, nearly all indices—Sensex, Nifty, small-cap index, etc.—tend to fall together. Since mutual funds don't offer built-in hedging options, a practical approach is to diversify into different asset classes.

One effective strategy is to establish a personal asset allocation rule. For instance, setting 50 per cent of the portfolio in equity and 50 per cent in debt can create a balanced approach. As equity markets rise, this allocation may shift, with equities potentially increasing to 70 per cent. In such cases, selling the excess 20 per cent from equities and moving it into debt can provide a partial hedge.

Years of market observation show that predicting short-term movements is challenging, and attempts at timing the market often lead to missed opportunities.

Instead, a disciplined asset allocation strategy, combined with rules for rebalancing, can be more effective. For example, rebalancing whenever any asset class moves 10-15 per cent away from the target allocation allows investors to benefit from both market rises and falls. With funds allocated to debt, investors can move money to equity during downturns. Without a diversified approach, an all-equity portfolio may lack funds to invest during dips.

An automated asset allocation and rebalancing strategy can act as a buffer, enhancing returns over time and reducing regret in the event of a market fall. This approach provides psychological comfort by cushioning against downturns while allowing for growth as the market rises.

Also read: Should new equity investors move to debt funds?

This article was originally published on November 12, 2024.