Pallav Multi-Strategy Fund can buy a put spread costing 1.5% of NAV a year that pays 12% of NAV if the market falls 25%. You think such a crash happens once in eight years. Is the hedge worth buying?

In expectation the hedge roughly breaks even, so buy it for the drawdown, not the return. Twelve points of premium over eight years buy one twelve-point payout. What changes is the crash year: the fund loses 9.5% instead of 20%, staying inside its 15% drawdown line. With the same average return and a smaller crash, the hedged fund also compounds to more, Rs 1.60 against Rs 1.56 per rupee over eight years.

Think of home insurance priced fairly: over a lifetime, the premiums roughly equal the expected claims. People still buy it, because the year the house burns is the year they could not survive without it. A 12% payout with a one-in-eight chance is worth 1.5% a year, the same as the premium, so on your own view the hedge is a wash. If crashes come once in twelve years instead, the expected payout is 1.0% a year, and the hedge costs about half a point a year net.

Staying in the game. A multi-strategy fund that loses 20% crosses its 15% line: capital is cut at the bottom, investors redeem, and the fund cannot be in the market for the recovery. Hedged, the crash year is minus 20% plus 12% less the 1.5% premium, minus 9.5%. The value of the hedge is the value of never being forced to sell at the worst moment, which does not appear in a one-year expected value.

No, and here it even helps. Run eight years with one crash. Unhedged: seven years of +10% and one of -20%. Hedged: seven of +8.5% and one of -9.5%. Both average 6.25% a year, but the hedged path compounds to Rs 1.60 per rupee against Rs 1.56, because a smaller loss needs a smaller gain to recover. Cutting the size of the worst year raises the growth rate even when the average is unchanged: 6.07% a year against 5.71%.

Three gaps. A put spread pays only between its strikes, so a 40% crash pays no more than a 25% one, and a 15% fall pays little or nothing while still hurting the fund. The fund's losses may not track the index: a crash led by crowded hedge fund positions can hurt Pallav more than the market. And the one-in-eight view is itself a guess; a hedge bought on a wrong probability is either wasted premium or too small. Close with the view: buy it as drawdown insurance, size it to keep the crash year inside the limit, and check the fund's actual sensitivity to a market fall every quarter.