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Hybrid Funds

You may have heard of equity funds and debt funds, but there’s another one you may not be very familiar with and that’s a hybrid fund. So what are hybrid funds? As the term suggests, a hybrid fund invests in multiple asset classes to cater to the need for varying levels of risk tolerance. Typically, the investments are made in a mix of equity and fixed income instruments.

What is a hybrid fund?

There are many kinds of hybrid funds. If a mutual fund invests a large proportion in equity, it’s called an equity-oriented fund. If it invests a major portion in debt, it’s called a debt-oriented fund.

An equity-oriented fund will invest mostly in the shares of companies in various sectors like pharma, information technology, infrastructure, mining and so on. This kind of fund offers higher returns, but the corresponding risks are higher too. A debt-oriented fund will focus more on fixed-income instruments like government securities, treasury bills, debentures by private companies and certificates of deposit. The risk here is lower, as are the returns.

What we know as balanced funds in India invest in a mix of equity and debt, generally in the ratio of 60:40. Of course, there are many variations in this ratio. A conservative fund will probably invest less than 50% in equities, while a higher risk fund can invest up to 70% in equity. Needless to say, a balanced fund with a higher equity component will have more risk than one with higher debt.

A balanced fund allows investors to choose a mix of equity and fixed income instrument according to their risk appetite and investment goals. A monthly income plan (MIP), for example, invests over 80 per cent of its funds in debt and the rest in equities. This enables investors to enjoy a regular income, while at the same time ensures they enjoy the benefits of the higher returns offered by the stock market.

Another hybrid mutual fund is the arbitrage fund, which takes advantage of price differences between the derivatives and cash segments of the stock market. However, arbitrage opportunities are not available all the time, so to ensure steady returns to investors, these types of hybrid mutual funds place part of their corpus in fixed income instruments.

Another type of hybrid mutual fund is the dynamic asset allocation fund, which changes the mix of equity and debt in its portfolio according to the demands of the situation. Fund managers invest more in equity when prices are low and less when prices are on the higher side. This has the advantage of reducing volatility, making this kind of hybrid fund attractive for risk-averse investors. Returns will depend on the skills of the fund manager and his ability to evaluate situations.

Multi asset fund is a type of hybrid mutual fund that invests in a combination of assets, like equity, debt and gold. These can be aggressive or conservative depending on risk appetite. Aggressive hybrid mutual funds of this type will invest most of its portfolio in equity.

Advantages of hybrid funds

  • Balance risk and return: The biggest advantage of a hybrid mutual fund is that it allows investors to balance risk and return. The equity portion will earn better returns, and the debt part will earn steady returns at lower risk. Investors can also choose the mix of equity and debt that is suited for their needs. For example, an aggressive balanced fund will invest, say, over 75 per cent in equities and the rest in debt. A conservative fund may invest less than 50 per cent in equity.

  • Diversification: A balanced fund offers investors the benefit of diversification since it combines both equity and debt. When share prices go down, the debt component in these kinds of hybrid mutual funds ensures stability. So these funds are able to withstand shocks during a bear phase. Generally debt and equity have an inverse correlation; they move in different directions. So having a balanced fund helps you hedge your bets. One thing you must remember is that balanced funds do not do as well when the market is on a bull run. Another point is that when share prices rise, fund managers will have to sell stocks in these kinds of hybrid mutual funds to maintain the required equity-debt ratio.

  • Suited for first time investors: Hybrid funds are especially suitable for first-time investors, especially in equity. They will get exposure to equity, but the risks are not too great when share prices rise and fall.

  • Systematic investment plan (SIP): Another advantage of a hybrid fund is that you can invest small amounts each month through a SIP depending on how much you can save. Is there an advantage in investing small sums over a period of time? Some feel that it doesn’t matter whether you invest in a lump sum or in instalments since you are investing mainly in debt. But it will matter if the hybrid funds have a higher component of equity, since you’re in danger of getting into the stock market when prices are high. In hybrid funds with a higher component of equity, it’s better to take the SIP route since you enjoy the benefit of rupee cost averaging.

  • Lower volatility: Equity funds are subject to the vagaries of the market. In a volatile market, investors could panic and opt out through redemptions. Having a debt component brings in a certain amount of stability to hybrid mutual funds, and fund managers will be able to handle redemptions better, ensuring stable returns to investors.

  • Higher returns: In some instances, hybrid funds have outperformed equity funds. Returns from hybrid funds during the past few years have been higher than large cap funds. This is particularly true in a volatile market.

  • Lower expenses: Since most balanced funds have a fixed proportion of stocks and bonds, and fund managers tend to place their bets on large cap stocks, there is very little need for active portfolio management. Hence, expense ratios will be on the lower side for hybrid funds.

Disadvantages of hybrid funds

  • Risks: There is a misconception that hybrid funds are risk free. This is not true. There are two kinds of risk involved in a balanced or hybrid mutual fund – fluctuations in stock prices and interest rates. If stock prices fall, NAVs will drop according to the proportion of equity in the fund. Balanced funds are also exposed to interest rate risk. When interest rates rise, NAVs will fall.

  • Less leeway for change: Balanced funds may not be ideal to meet changing investment goals. For example, if you want to reduce your exposure to equity, you will not have that option with a hybrid mutual fund.

  • Difficult to compare: Another problem with hybrid funds that it’s difficult to compare returns. In equity funds, for instance, you can compare the performance of your fund to an index like the Sensex, or specific indices like large cap, mid cap and small cap. You won’t be able to do this with a hybrid fund. The only comparison you can make is with hybrid mutual funds in the same category.

  • Lack of focus: Managing debt and equity needs different skill sets, and managers of hybrid funds may not have enough expertise in both fields, leading to sub-optimal returns for investors. You need to take a close look at the fund manager’s expertise and the track record of the hybrid mutual funds before making any investments.

Tax treatment of hybrid funds

Equity-oriented funds, with more than 65 per cent in equities, have the same tax treatment as equity funds. If you hold them for less than a year, you pay 15 per cent capital gains tax. Hybrid mutual funds of this type held for over a year are eligible for long-term capital gains tax at 10 per cent. Hybrid mutual funds investing mainly in fixed income instruments are treated as debt funds. They are eligible for long-term capital gains tax of 20% with indexation if you hold them for three years and above. Any short-term gain is added to your income and tax according to your tax slab. Indexation reduces the amount you have to pay as tax, so you get that benefit.

How to choose the right hybrid fund

  • Risk appetite: Balanced funds have a mix of equity and debt in varying proportions. If you are able to bear a higher level of risk, you should choose hybrid mutual funds that have an equity component of 85 per cent. If you want moderate risk, one with an equity component of 60 per cent should work for you. There are also schemes of hybrid mutual funds that cater to low-risk investors, with an equity component of 15-25 per cent.

  • Monitor performance: The best way to monitor the performance of hybrid mutual funds is by checking their returns over several years. Choose a balanced fund that has shown steady performance in bull and bear phases. You can download the Angel Bee app to monitor mutual fund performance. Its ARQ hyper-intelligent investment engine helps you select the best hybrid mutual funds.

  • Expense ratio: The expense ratio is the amount charged by hybrid mutual funds to manage your investment. Make sure the expense ratio of the scheme you chose is low. Higher expense ratios will eat into your returns.

  • Time horizon: You have to hold balanced funds for at least five years before you are able to realise the full benefit of these kinds of hybrid mutual funds.

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