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What are 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 is a hybrid fund? 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?

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 moderate 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 percent 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.

Then there are arbitrage funds, which take 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, arbitrage funds place part of their corpus in fixed income instruments.

Another kind of hybrid is a fixed maturity plan, which invests in a mix of debt and equity. These are close-ended funds with a fixed tenure.

Advantages of hybrid funds

  • Balance risk and return: The biggest advantage of a hybrid 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 percent in equities and the rest in debt. A conservative fund may invest less than 50 percent 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 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, the fund manager will have to sell stocks in the fund 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.

  • Tax benefits: Equity-oriented funds, with more than 65 percent in equities, have the same tax treatment as equity funds. If you hold them for less than a year, you pay 15 percent capital gains tax. Funds held for over a year are eligible for long-term capital gains tax at 10 percent. 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. 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 one that has an equity component of 85 percent. If you want a moderate risk, one with an equity component of 60 percent should work for you. There are also schemes that cater to low-risk investors, with an equity component of 15-25 percent.

  • Monitor performance: The best way to monitor the performance of 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 mutual fund schemes.

  • Expense ratio: The expense ratio is the amount charged by the mutual fund 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 a balanced fund for at least five years before you are able to realise its full benefit.

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