Investing’s hybrid – the hybrid fund – straddles two asset classes to promise benefits.
Source: Tavaga Research
Hybrid Funds
Hybrids are born out of the need to straddle two worlds at the same time. Need the option to fill up at a petrol pump but still try and help the environment with a ride running on battery? Why, drive home a hybrid car, of course. Troubled with the seasonality of farm produce? Sow the seeds of a hybrid alternative with traits of a season-resistant crop. Among investment funds, we have hybrid funds, which try and bring us the best of both the worlds of debt and equity. They are also called balanced funds.
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What is the meaning of hybrid funds?
As the name suggests, hybrid or balanced funds are invested in a mix of debt and equities securities. As investors in mutual funds, we may have faced the dilemma of which to pick for our money goals. Inevitably, we end up referring to our risk appetite to choose between debt and equity.
But we need to keep diversification in mind as well. The modern portfolio theory says the objective of diversification is to reduce unsystematic risk.
Could an investor, then, have some equity securities to create wealth and some debt securities to meet day to day expenses? What if an investment fund does the balancing act for us? This is where hybrid funds come in handy, and reduce the unsystematic risk by investing in more than one asset class.
Hybrid funds’ returns are determined by the makeup of the funds and the risks they take.
Types of hybrid / balanced funds
From the various types of mutual funds available in India, Hybrid funds in India have different leanings. Depending on the degree of their exposure to equity and to debt securities, hybrid funds are classified as:-
Conservative hybrid funds
These follow a conservative investment strategy and allocate a significant portion of their assets to low-risk investment products such as bonds and money-market securities. The main objectives of the funds are principal protection and providing a steady income to their investors. Although the funds invest primarily in low-risk assets, there would still be a small portion invested in equity and equity-linked instruments.
As per Sebi guidelines, conservative hybrid funds should have an allocation of 75 – 90 percent in debt assets and 10-25 percent in equity and equity-related assets. Investors who are risk-averse may invest in conservative hybrid funds. It is beneficial for those of us who seek a steady flow of income rather than wealth-creation. Historically these funds have provided a return in the range of 6.50 – 7.00 % on average.
Balanced hybrid funds
Investors who are still unsure about their risk profile should consider investing in a balanced hybrid fund. These funds invest in debt and equity securities in roughly the same weightage, as in have an almost equal allocation in each. Sebi defines the fund’s characteristics as those which invest around 40-60 percent of the assets in each. Historically these funds have provided a return in the range of 7 – 9 % on average.
Aggressive hybrid funds
Investors who are willing to take greater risk may invest in aggressive hybrid funds. These have an equity orientation, investing in more equity securities than debt instruments. Sebi’s guidance dictates these allocate anywhere between 65-80 percent assets in equity and equity-related products. The rest is invested in debt schemes. Historically these funds have provided a return in the range of 7 – 8 % on average.
Investors who are willing to take greater risk may invest in aggressive hybrid funds. These have an equity orientation, investing in more equity securities than debt instruments. Sebi’s guidance dictates these allocate anywhere between 65-80 percent assets in equity and equity-related products. The rest is invested in debt schemes. Historically these funds have provided a return in the range of 7 – 8 % on average.
Dynamic asset-allocation fund
These balanced funds invest in both equity and fixed-income instruments and change the asset allocation of the portfolio according to the changes in market conditions. These leave their allocation ratio open to tactical changes to make the most of the situation. For example, when the interest rates are low, the assets may be invested largely in equity and equity-linked instruments and vice versa. The rationale being low-interest rates lead to companies borrowing more to increase their economic activity. It creates an opportunity for shareholders to maximize their wealth. Such hybrid funds have provided returns of 7-9 percent on average in the past.
Multi-asset-allocation funds
These invest in different asset classes. Sebi defines them as funds that invest in at least three asset classes, with a minimum allocation of at least 10 percent in each of them. We should note that foreign equities are not considered as a different asset class. These funds have historically provided a return of 10 – 12 percent on average.
Arbitrage funds
The objective of these funds is to generate capital appreciation and income by predominantly investing in arbitrage opportunities in the cash and derivative segments of the equity markets. The Scheme will endeavor to invest predominantly in arbitrage opportunities between spot and futures prices of exchange-traded equities and the arbitrage opportunities available within the derivative segment. These funds have historically provided a return of 6 – 7 percent on average.
Equity savings fund
This scheme invests in equity and related instruments, and as mandated by Sebi, is required to have a minimum of 10 percent in debt related instruments even with at least 65 percent of the total assets invested in equity-linked instruments. Hence, such funds are called equity savings funds. These schemes also look out for arbitrage opportunities in the market. These schemes have provided a return of around 7- 8 % in the past.
Hybrid funds’ taxation rules
Conservative hybrid funds
For short-term capital gains (where the holding period is less than 36 months) from the sale of its units, the tax is deducted according to our income-tax slab, whereas for long-term capital gains (holding period of more than 36 months) the tax of 20 percent is deducted with the benefits of indexation.
Balanced hybrid funds
These are taxed the same way as conservative hybrid funds.
Aggressive hybrid funds
Since equity forms the majority of the investment-holding, these funds are taxed as equity funds. If the units are sold for a profit within the first 12 months of investment, it is considered as short-term capital gains and are taxed at 15 percent. If profits are made by selling the units after the first 12 months of ownership, then it is treated as long-term capital gains and taxed at 10 percent if gains are more than Rs 1 lakh, without any indexation benefit.
Dynamic asset-allocation fund
Taxation depends on which asset class is the fund majorly exposed to.
If the fund has more than 65 percent of its assets allocated in equity or equity-linked instruments, the taxation is at par with equity funds.
If the holdings are less than 65 percent in equity-related instruments, then it gets taxed like a debt fund, much like conservative hybrid funds.
Multi-asset-allocation funds
Short term capital gains in multi-asset allocation funds if held for less than 3 years, are added to the investment income and is taxed according to his tax slab, whereas the long term capital gains arising from the scheme is taxed at 10% with indexation benefits.
Arbitrage funds
These are taxed in the same way as aggressive hybrid funds.
Equity savings
These funds are treated as equity schemes for the purpose of taxation, much like aggressive hybrid funds.
Hybrid funds vs equity funds
The focus of hybrid funds is to reduce unsystematic risk as much as possible through diversification. This helps us to earn some steady income by investing a relatively large portion of the assets in debt funds.
On the other hand, equity funds focus on wealth creation. The minimum asset allocation in equity and equity-linked instruments is at least 65 percent, Sebi classifies equity funds as a multi-cap fund, large-cap fund, large- and mid-cap fund, mid-cap fund, small-cap fund, dividend-yield fund, value fund, contra fund, focused fund, sectoral/thematic fund and ELSS (equity-linked saving scheme).
Hybrid Funds Expense Ratio
The expense ratio for a broad category of hybrid funds can be summarized as follows.
Who is the audience for hybrid funds?
These funds are suitable for the conservative investor among us who wants to earn a stable income on our portfolio and still have an option to earn high returns from an equity component.
The debt component provides a cushion against extreme market movements, and the equity component provides us an opportunity to earn high returns.
Are hybrid funds a good option?
It may sound like an answer to an investing dilemma but hybrid funds are far from it. Hybrid funds have a risk associated with them which retail investors like us should be aware of.
Their debt exposure makes these funds vulnerable to crises of liquidity when the security-issuing company defaults on its debt papers. The AMCs of such funds, holding these papers as part of their portfolio for investors take the hit, which can erode the investors’ money.
The recent Vodafone idea fiasco saw Franklin Templeton’s low duration fund take a hit, and it was so severe that a single m-day NAV was down by 6.87 percent. Hybrid funds have significant exposure to debt instruments.
The rationale behind investing in hybrid funds is to make sure that the investment has a stability of return and achieve diversification benefits at the same time. But in achieving these objectives with the help of hybrid funds, we end up paying an expense ratio of around 0.90 – 1.10 percent on an average which later on eats into our returns.
A better alternative to hybrid / balanced funds
A better way of achieving the stated objectives of stability of income and diversification may be that of setting up a portfolio to invest in different asset classes based on our risk appetite and market conditions.
Of course, it is a more circuitous route, and perhaps, that is why hybrid funds came into existence. But going a la carte in choosing our asset classes and securities might help us protect more of our returns. An investment adviser is best placed to unravel some of it for us but we should ensure they are a Sebi-registered investment adviser before taking our portfolio concerns to them.