SAVE FOR TOMORROW : Mutual Fund-Smart strategy

Using a few hedging tools

One invests in mutual funds for higher rates of return. But one must not lose sight of the fact that preservation of the invested amount is more important. Hedging is the way out

Alok Dwivedi

Profit is the only concern of every investor whether he invests in the stock market or mutual funds. But things don’t go according to plans. No matter how well your research is, there are always chances of it going wrong due to several factors like poor market sentiments, wrong information or change in policies. Hence, it is always important to go for hedging against investment.

Hedging is a tool of reducing the exposure risk in any investment instrument. It is a tool not for making money or increasing profits but for protecting investment against unforeseeable losses. Another thing to keep in the mind is that the use of hedging may reduce the expected profit. At the same time, reduces the chances of probable losses. In this article, we would discuss the use of hedging in the mutual fund space.

Proper asset allocation

As far as mutual funds are concerned, the goal of hedging is to reduce the risk involved in building a portfolio. If we look at it technically, it is essential to go for two financial products which have negative correlation. But, first of all, making a proper asset allocation plan is the initial step towards hedging a mutual fund portfolio. For this, one has to divide one’s funds between various mutual fund schemes. This would ensure that the investor doesn’t have to bear losses because the performance of various schemes is not similar in a given period of time. All mutual fund schemes in the portfolio wouldn’t go down or go up at the same time.

Going for index funds

Asset allocation is not the only remedy as far as hedging tools for the mutual fund portfolio are concerned. As the index comprises stocks from a number of sectors, such funds are exposed to a wide variety of sectors. It ensures that if one sector tends to underperform, other sectors with outperformance help the index to remain in good health. Hence, one way of doing it in the mutual fund space is to increase the proportion of index fund in the portfolio. But this should be done by only those investors who go for equity-dominated portfolio.

Using defensive sector funds

As we all know, every sector moves ahead with its economic and business cycles. Hence, there are always chances that if one sector is showing the downward movement, the other one would be going upwards. The smartness of the investor lies in choosing the appropriate sectoral fund. Usually defensive sectors like the pharmaceutical and FMCG sectors do well during turbulent times. Hence, sectoral funds based on these sectors can be used looking at the market scenario. If the markets go northwards, one may increase the exposure in sectors with momentum and reduce exposure in defensive sectors. But in turbulent times, one may change one’s strategy and use defensive sector funds as hedging tools. Pharma funds, for instance, can be given place in the mutual fund portfolio as a hedging exercise.

Debt mutual funds

Exposure in various types of mutual funds depends on the age and risk profile of investors. It is seen that young investors and investors, with greater risk taking capacity, avoid investing in debt mutual fund schemes. It is always better for them to hedge their risks in mutual fund investment. If one is exposed heavily in equity-related mutual funds, one can hedge this risk by investing in debt funds.

One should note that returns provided by these mutual fund schemes are more tax efficient. First of all, the long-term capital gains from these schemes are taxed with the benefit of indexation. Secondly, tax on dividend is lower than the rate of income tax. Due to these reasons, these schemes offer higher post-tax returns to its investors. Gilt funds, which invest in various types of medium- and long-term government securities, can be chosen as a hedging tool by investors who have major exposure in equity-based mutual fund schemes.