Dealing with volatility: Balanced funds or put options for downside protection?We have received a number of queries asking us to compare balanced funds with those funds using put options to protect the downside. A put option gives the holder of the put, the right but not the obligation to sell a stock at a given price. The holder of the put starts making money, as soon as the value of the concerned stock drops below the price specified in the put. In return, the holder pays out a fixed sum or ‘premium’.

A balanced fund, according to the new SEBI classification rules can invest between 40% and 60% of its assets in debt and the rest in equity. The fund manager can switch between debt and equity as per his outlook on the markets and thus reduce the risk in the fund. Note, however, that the discretion to switch is limited, the manager cannot allocate less than 40% to equity.

There are two other categories of open-ended funds according to SEBI rules, which give the fund manager more freedom to move between equity and debt. Dynamic Asset Allocation Funds impose no constraints on the fund manager in terms of allocation between these assets. Multi-Asset Allocation Funds specify a minimum of three assets and a minimum of 10% of the fund’s corpus in each. In other words, the fund must hold at least 10% in equity.

Some funds use derivatives such as put options to protect their downside. One such recent launch is the IIFL Capital Enhancer Fund (we reviewed it here) which uses one-year put options to hedge its downside. The fund has set a one-year lock-in for investors, coinciding with the length of the puts it will buy. The fund points out that this will not only align the put options with the equity exposure of the fund but it will also prevent investors from exiting the fund in a panic if the markets correct.

A put option if used to hedge the entire value of the fund can eliminate almost all downside. The only cost it pays is the fixed cost of the premium. On the other hand, if markets move up or end higher than they started at the time of the maturity of the put, the premium ‘gets wasted’ and the fund underperforms.

Funds such as Kotak India Growth Fund and DSP Blackrock ACE Fund Series 2  open up a third possibility. They allow the fund manager to move in and out of puts according to market levels instead of specifying that the put will be held for a specified time period. In these funds, the downside will be protected so long as the manager holds on to the put. If he sells it and the markets keep falling, the fund will lose value. On the other hand, if the manager sells it and markets subsequently rise, the fund will outperform its unhedged peers and as well as those funds holding puts for defined periods.

The answer to this question depends on an investor’s need for liquidity and safety.

A fund which hedges its entire equity allocation with puts such as IIFL Capital Enhancer will provide a high degree of safety but low liquidity (you are locked-in for a year). The rigidly defined time period for the fund’s put options can also cause the fund to underperform its unhedged peers.

Funds such as Kotak India Growth Fund and DSP Blackrock ACE Fund Series 2 are close-ended and also compromise on liquidity. However, by giving the discretion to the fund manager to move in and out of puts, they open up the possibility of higher returns and also higher risk.

Balanced funds are open-ended and typically only impose exit loads up to one year as a check on liquidity. On the other hand, they have to invest 40% of their assets in equity. In other words, they score well on returns and liquidity but offer a lower level of safety. But these constraints are absent in dynamic asset allocation Funds and much lower in multi-asset allocation funds.

The choice between these different types of funds depends on how much importance you give to each parameter – liquidity, safety and returns

Author
Neil Borate

Neil Borate is Deputy Editor, RupeeIQ. He can be contacted at neil@rupeeiq.com.