Looking for a way to diversify your investment portfolio and balance risk and return? Look no further than hybrid funds! These investment vehicles offer a unique blend of stocks and bonds, providing investors with a diversified portfolio that can help weather market ups and downs. With the potential for higher returns and capital preservation in times of market volatility, investing in hybrid funds could be the perfect addition to your investment strategy. Read on to get an overview about what this exciting investment opportunity is and how it can help you achieve your financial goals!
What are hybrid funds?
Hybrid funds are mutual funds that invest in both equity and debt instruments. Hybrid funds primarily invest in equity and equity-related securities of companies of various sizes to achieve growth in the value of investments over a long-term period and additionally invest in debt and money market instruments with the aim of generating a steady income. The equity portion of the hybrid fund thus offers potential for capital appreciation while the debt component provides stability to the returns and generates regular income. Hybrid funds offer a viable substitute to equity funds and you can invest in these funds if you are a new investor seeking equity exposure with less risk and want to save for long-term financial goals in volatile markets. Hybrid funds are also suitable for investors who are looking for a balanced portfolio with both growth and income potential, while also diversifying their investments across asset classes.
How to evaluate hybrid funds?
The risk and return of hybrid funds can be determined by examining how the fund's assets are allocated across various asset classes and how each class is managed. To evaluate a hybrid fund's risk, it is important to analyse the type and degree of equity exposure typically taken by the fund. In addition to considering the allocation of assets between equity and debt, it is important to assess the risk associated with each component separately. Selecting the appropriate combination of hybrid funds can be a challenging task as there are six categories of funds, namely, conservative hybrid funds, balanced hybrid or aggressive hybrid funds, dynamic asset allocation or balanced advantage funds, multi asset allocation funds and arbitrage funds. Each of these funds has a unique asset mix and investment strategy. Below, you will find a brief overview of each category of hybrid funds, including the benefits they offer to investors.
TYPES OF HYBRID FUNDS:
1. Conservative Hybrid Funds:
Conservative hybrid funds allocate a larger portion of their portfolio typically between 75-90% to debt instruments and invest the remainder i.e. usually between 10-25% in equity instruments. When evaluating conservative hybrid funds, it is important to note that the term "conservative" refers only to the equity allocation. Therefore, it is necessary for you to examine how the equity portion of the fund is managed, including factors such as the size and diversity of the stocks held across different sectors. This assessment can help you determine the suitability of the investment. It is also important to review the credit quality of the debt portfolio, as well as the duration risk that the scheme may be exposed to.
You can consider investing in conservative hybrid funds if you are looking to earn slightly higher returns than bank fixed deposits and pure debt funds without taking on too much additional risk. However the minimum time horizon for investing in these funds should be three years.
In the past, they were known as monthly income plans, but due to the volatility brought on by the equity component, they are not ideal for delivering monthly income. The tax structure for conservative hybrid funds is the same as that of debt funds.
2. Balanced Hybrid or Aggressive Hybrid Funds:
There are two sub-categories here: Balanced hybrid funds and aggressive hybrid funds.
- Aggressive Hybrid Funds:
Aggressive hybrid funds allocate 65-80% of their portfolio to equities and the remaining portion to debt. If either asset class exceeds its stated limits, the fund rebalances the portfolio back to its fixed allocation. As these funds are required to invest at least 65% in equities, both dividends and capital gains are subject to similar tax treatment as equity mutual funds. Dividends received are taxed as per your applicable income tax slab rate, while long-term capital gains (over ₹1 lakh) are taxed at 10% (without indexation) after one year. Short-term gains made on units sold within a year are taxed at 15%. To benefit by investing in these funds, the ideal investment time horizon would be 3 to 5 years.
Factors to consider while investing in Aggressive Hybrid Funds:
You should consider three factors when choosing to invest in aggressive hybrid funds since different fund houses may handle the equity and debt portions of the funds in distinct ways.
The first aspect to observe is whether the fund retains its equity allocations within a strict range (such as 65-80%) or varies them significantly based on market conditions. If the fund deviates by a big margin from the range, it means the fund manager tries to time the market more frequently, which can occasionally result in errors.
The second aspect you should pay attention to when choosing aggressive hybrid funds is how the fund allocates its equity portion among large-cap, mid-cap and small-cap stocks. Funds with a greater allocation to large-cap stocks (over 65 percent) are more likely to perform better in turbulent or declining markets than those with higher mid-cap or small-cap allocations.
Thirdly, in context of debt investment of the fund, you should consider whether the fund invests in very long-duration bonds or lower-rated corporate bonds to deliver a high yield. A fund with a low average maturity that invests in highly rated bonds will provide less risky debt returns compared to one that takes higher risks.
- Balanced Hybrid Funds:
Balanced hybrid funds aim to achieve a balanced approach to investing by managing their equity and debt exposures within the range of 40 to 60 per cent. These funds do not employ arbitrage positions and offer an equal mix of equity and debt investments, making them a suitable choice for risk-averse investors who seek a stable debt foundation along with some equity exposure. In contrast to aggressive hybrid funds, which allow for higher equity allocations, balanced hybrid funds provide a more balanced allocation between both debt and equity.
Hybrid funds, particularly balanced funds, have gained popularity due to their ability to offer equity-like returns with low risk. By investing in both equity and debt, these funds provide the benefits of asset allocation and automatic rebalancing. However, the increase in demand for hybrid funds has led to the introduction of various new variations. Opting for simple balanced funds with a proven track record is still the most reasonable approach. While choosing a balanced fund, it's essential to examine its equity-debt mix, market-cap mix and equity and debt strategies, in addition to its performance.
Achieving the right asset allocation involves combining volatile assets like equities with stable ones like debt in the appropriate ratio, so that fluctuations in one are offset by stability in the other. However, maintaining this mix is not the only important factor; it also requires consistent adherence to the predetermined allocation through regular rebalancing. In India, balanced funds have effectively accomplished both objectives, which is reflected in their impressive long-term performance.
Over time, the 60-40 or 40-60 percent allocation between debt and equity has proven to be more effective than other ratios in generating stable returns for long-term investors. This success is not solely due to the proportion of debt and equity, but also to the rebalancing feature of balanced funds, which contributes to their favorable performance.
The tax treatment of balanced schemes is determined by the scheme's investment portfolio, which can result in the scheme being taxed as an equity scheme or a non-equity-oriented scheme.
3. Equity Savings Funds:
Equity savings funds are hybrid funds that use a mix of equities, equity-arbitrage and debt investments to provide investors with returns similar to those of debt funds. By maintaining at least a 65 percent equity exposure through stocks and arbitrage positions and a minimum of 10 percent of total assets in debt, these funds receive the tax benefits of equity funds, making them appealing to investors looking for stable returns and tax efficiency. You can invest in these funds if you can keep a time horizon of three years and more.
Factors to consider while investing in Equity Savings Funds:
When selecting equity savings funds, you should consider three factors:
First, whether the allocation among equity, debt and arbitrage is static or dynamic, as dynamic allocation may involve greater risks.
Second, whether the equity portion is more heavily invested in large-cap or mid-cap and small-cap stocks, as mid-cap or small-cap weights may increase volatility of returns generated by the fund.
Third, whether the debt portfolio includes lower-rated bonds, as it may carry default risks.
4. Dynamic Asset Allocation or Balanced Advantage Funds:
Dynamic asset allocation, which are also referred to as balanced advantage funds, employ a flexible asset allocation approach based on market conditions and invest in debt/equity dynamically to provide investors with optimal returns while minimising risk. They typically invest in a mix of equity, arbitrage and debt with a focus on having at least 65 percent of the allocation in equity and arbitrage and get tax treatment similar to equity mutual funds.
These funds aim to increase their exposure to stocks during periods of bullish equity markets and allocate more to bonds when the bond market is favourable. Investing in dynamic asset allocation funds can benefit you by booking profits when markets rise and investing more when markets correct. This approach allows you to potentially take advantage of market movements while reducing overall risk. Another key advantage of dynamic asset allocation funds is their use of model-based triggers. These triggers help the fund manager determine the adjustments needed to deliver consistent and stable returns. This approach can potentially reduce the impact of market volatility on the fund's performance.
These funds are a good fit for those who desire to realign their equity allocation with market levels and achieve greater pre and post-tax returns than balanced hybrid funds and have an investment horizon of three or more years. This longer-term investment horizon can allow investors to potentially benefit from the fund's active asset allocation strategy and potentially enhance their overall returns.
5. Multi Asset Allocation Funds:
Multi-asset allocation funds are designed to invest in three or more asset classes, which typically include equity, debt and gold. These funds are permitted to engage in tactical allocation with a minimum of 10 percent allocation to each asset class.
Diversifying the investment portfolio across different asset classes mentioned above can provide various benefits. Equity investments can provide opportunities for capital appreciation, while debt investments can generate a regular income stream. Gold can serve as a hedge against inflation and geopolitical risks. A well-balanced combination of these asset classes can result in optimal risk-adjusted returns for your portfolio. You can consider investing in a multi-asset fund if you prefer the convenience of a investing in different asset classes through a single fund. If the equity component of the fund exceeds 65%, you can benefit from favorable equity taxation. In contrast, investing separately in each asset class would result in different tax implications for debt and gold investments. Besides, a multi-asset fund manager can actively adjust the portfolio's asset allocation based on the underlying returns of each asset class. This approach can effectively balance the portfolio and potentially enhance overall returns.
Multi-asset allocation funds are thus ideal for you if you have a low risk tolerance but desire consistent returns on your investments. By diversifying across multiple asset classes, these funds help mitigate the risk associated with investing in a single asset class. Moreover, they can provide a stable income stream even during periods when certain asset classes are underperforming. These funds come with automatic portfolio rebalancing options to ensure that the investments are well-distributed among different asset classes. This is particularly beneficial during market volatility. Investing in a multi asset allocation fund allows you to benefit from a ready-made portfolio and avail the advantages of various asset classes without the need to create a custom-made portfolio by a professional. It is suitable to invest in these funds if you have a time horizon of at least 3 years.
6. Arbitrage Funds:
Arbitrage funds are open-ended mutual fund schemes that have a minimum investment of 65 percent of total assets in equity and equity related instruments. Arbitrage funds aim to profit from discrepancies between the cash and derivatives markets, generating income for investors. This method allows you to earn returns without direct exposure to equity market risks. By investing in both stock and futures, these funds mitigate volatility associated with equity funds. While arbitrage funds are generally considered to be low-risk investments, they still have the potential to generate higher returns than traditional fixed-income investments because the fund manager is able to identify and exploit price discrepancies in the market. Besides, arbitrage funds are subject to equity taxation, which means that you can benefit from more tax-efficient returns when compared to fixed deposits. This is because long-term capital gains from equity investments are taxed at a lower rate than fixed deposits. Arbitrage funds are generally suitable if you have a short-term investment horizon of 1-3 years because the opportunities for profit in the arbitrage market are often short-lived.
Risk-Return Hierarchy of Hybrid Funds:
Arbitrage Fund – Equity Savings Fund – Conservative Hybrid Fund – Dynamic Asset Allocation or Balanced Advantage Fund – Multi Asset Allocation Fund – Balanced Hybrid Fund – Aggressive Hybrid Fund |
Benefits of investing in hybrid mutual funds:
Many investors have had negative experiences with equity investing due to capital losses resulting from poor timing in equity markets. Similarly, new investors often give up on their investment plans when they face significant losses early on. However, hybrid funds are more effective in limiting losses from a stock market crash compared to pure equity funds, even if an investor had a poor start with their investments. Hybrid funds offer a more controlled exposure to equity, leading to a better return experience even in unfavourable market conditions. Hybrid funds can utilise equity instruments to generate sufficient returns to combat inflation and debt instruments to provide a stable cushion to portfolio returns, particularly during unfavourable market conditions. Even in aggressive hybrid funds, you can expect 20-35% of your portfolio to produce reasonable returns without being affected by market volatility due to the presence of debt in the hybrid fund portfolio. Besides, debt managers can employ both credit and duration strategies to produce a basic return, thus helping hybrid funds to withstand rising rates.
One of the key advantages of investing in a hybrid fund is that it can help you avoid making emotional investment decisions based on short-term market movements. Retail investors often fall prey to the temptation of buying when the market is rising and selling when the market is falling, which can lead to significant losses over time. Hybrid funds can help you stay disciplined by providing a diversified portfolio that is managed by a professional fund manager.
It is said that determining the asset allocation between equity and debt is a more critical decision for investors than selecting specific stocks or bonds for their portfolio. Hybrid funds provide an easy solution by offering pre-mixed combinations of debt and equity. Moreover, while it can be challenging for you to monitor your asset allocation regularly and periodically rebalance your portfolio to your preferred allocation, hybrid funds automatically handle this rebalancing for you with no action needed from your end.
Hybrid funds help amateur investors to overcome negative behavioural tendencies by adhering to a relatively stable allocation between equity and debt. Investment in these funds prevents retail investors from timing the market and escape the buying high and selling low phenomenon. By implementing a predetermined allocation, hybrid funds sell either equity or debt after it has performed well and invest in the down and out asset automatically, eliminating emotional investment decisions. This automatic rebalancing ensures that investors buy low and sell high, resulting in a more rational approach to investing.
Investing in hybrid funds is the most tax-efficient way to construct a diversified portfolio. If you hold equity and debt funds separately, you may encounter a tax liability on both short-term and long-term capital gains when rebalancing your portfolio to align it with the desired allocation. This could considerably decrease your ultimate investment returns. However, mutual funds, acting as pass-through entities, are not taxed when they adjust their portfolios, passing on the full benefit of rebalancing to the investor. Additionally, owning debt exposure through hybrid funds enables you to benefit from equity taxation advantages on the debt portion of your returns. In contrast, owning debt funds separately necessitates higher tax rates on both capital gains and dividends received.
Should you invest entirely in hybrid mutual funds?
It should be noted that hybrid funds, despite being less risky than pure equity funds, are not entirely risk-free. You may experience capital losses if there is a significant stock market crash, depending on the equity exposure and management style of the fund. The debt portion of the fund may also experience low returns due to interest rate movements and the performance of corporate bonds in the portfolio. As a result, it is advisable to hold hybrid funds for at least five years and not to rely too heavily on them for your regular income needs. It is also recommended to use the Systematic Investment Plan (SIP) route for investment and avoid lump-sum investments when investing in these funds. Despite their tax efficiency compared to fixed deposits or debt funds, it is still best not to rely too heavily on any single hybrid fund.
Conclusion
Hybrid funds have become a popular investment option for investors with diverse risk preferences and investment horizons to implement asset allocation. These funds provide the flexibility to invest in both debt and equity, allowing you to customise your portfolio according to your investment goals and retain control over the allocation of funds to each asset class over a specified period. You can thus create a portfolio that aligns with your risk tolerance and investment objectives by investing in hybrid funds.
