Navigating the World of Hybrid Funds

There is a lot to choose from hybrid funds. Know the many types and how they function to choose the one that meets your needs

Seasoned investor understands that exposure to equities has a high chance of experiencing volatility and even short-term losses, considering the real-time movement of stock markets. At the same time, every mutual fund investor seeks to optimise returns with minimal investment risk. The hybrid fund category exists to address such a need by providing options to investors by way of optimally managing investment risk and returns. Hybrid funds are designed to provide growth potential over time by managing volatility and investment risk. Hybrid Funds work on the principle of asset allocation to minimise the impact of volatility by investing across asset classes with low correlation like equity, debt, and gold to suit the risk appetite of investors. For instance, equity allocation allows you to participate in the upside, debt intends to provide stability and gold allocation usually acts as a hedge against fluctuation in equity and debt. By following a mix between the two with different allocations; these funds attempt to manage the impact of volatility on portfolio returns. These funds are suitable for investors who are looking for capital appreciation at a manageable risk, as these funds carry lower risk than pure equity mutual funds.

To ensure uniformity in the characteristics of similar type of schemes launched by different Mutual Funds, SEBI came up with the Categorization and Rationalization of Mutual Fund Schemes in 2017, detailing out the composition and variety of hybrid funds. Broadly there are 7 types of hybrid funds (See: The World of Hybrid Funds). Among these categories, there is plenty to choose from for investors and there is diffe ence between the funds given their asset allocation and risk-return potential. For instance, the Aggressive Hybrid fund offers a high equity allocation which could range between 65 and 80%. Conservative Hybrid Funds are at the opposite spectrum of Aggressive Hybrid Funds in terms of asset allocation and risk with equity allocation of 10-25% and 75-90% in debt instruments, hence less risky. The Balanced Hybrid and Equity Savings category have varying equity and debt allocation between the extreme ends seek to provide a moderate risk and growth prospect to investors.

Within the hybrid category, the multi-asset category offers a unique investment choice. Funds in this category invest a minimum of 10% of their portfolio in at least 3 asset classes (generally equity, debt and commodities like gold). They somewhat practise the philosophy of benefiting from the upside of one of the asset classes, while managing the downside risk. A mix of assets allows such funds to view the big picture with the ability to capture opportunities and mitigate risk across different economic cycles and market environments. managing the downside risk. A mix of assets allows such funds to view the big picture with the ability to capture opportunities and mitigate risk across different economic cycles and market environments. For investors, these funds offer a tailor-made portfolio to invest in to suit their investment objective and returns potential. Moreover, it is difficult to correctly choose the right asset class for investing, because all asset classes perform differently in a given period. This category of fund with its allocation to different classes, especially gold offers a solution to this problem.

This type of hybrid fund generates return by using the strategy of simultaneously buying and selling of securities in different markets to take advantage of different prices. The advantage of following such a strategy is that there is minimal stock market risk when investing with such a strategy because the buying and selling price of a stock is known to the fund manager. The arbitrage strategy is used by evaluating the price difference in the price of a security in the spot and the futures market. If the price is higher in the spot market, the fund manager buys the security in the futures market. At the same time, the fund manager will sell the same quantity of the security in the spot market. The difference between the prices of the security in both the markets is the gain, excluding other costs. The arbitrage strategy minimises investment risk, thereby providing investors in such funds the upside of equity investments at a lower risk. The ‘Theory of Loss Aversion’ by Daniel Kahneman and Amos Tversky, expresses investor concerns very nicely. The pain of losing is psychologically about twice as powerful as the pleasure of gaining. After all, no one wants to lose money when investing. Dynamic asset allocation fund is a type of hybrid fund which has used this investor concern to its advantage in building an investment approach. Investors who wish to see lower volatility in the long run may choose to invest in dynamic asset allocation funds (See: Understanding Dynamic Asset Allocation Funds).

That hybrid funds could be equity- oriented or debt-oriented; the way they are taxed depends on their type. A fund that has a minimum of 65% in equity or equity-oriented securities is deemed as an equity- oriented fund for the benefit of computing tax. All other schemes are deemed as debt-oriented funds and taxed accordingly (See: Taxation of Mutual Fund Schemes). Arbitrage funds and even some of the multi-asset funds within the hybrid fund category benefit from their equity classification when taxation is applicable. Do check on how the hybrid fund you invest will be treated for taxation on gains and plan your investment in them accordingly. However, the choice of fund should not be driven only on taxation; it should be based on your need and the fund’s suitability to your financial goal and risk profile.

Hybrid Funds are gaining acceptance among all types of investors as indicated in the data on assets inflow into this category in recent years. These funds are suitable to all investors as the choice of funds ranges from low risk to high risk category. Investors seeking growth or income could also consider investments in these funds, as these funds invest within a range in equities. Hybrid funds are mostly suitable for first-time investors, limiting their exposure to equity and providing adequate security against fluctuating stock markets. Investments in such funds also allow them to learn the behaviour of the equity market while limiting their risk exposure. One has the choice of investing in lump sum as well as through SIP (systematic investment plan) when investing in these funds for optimum outcomes. If the investment horizon is for the long-term, invest through SIPs with additional lump sums from time-to- time if possible. The main advantage of a hybrid mutual fund is that it allows investors with basic investment strategy of following asset allocation and diversification. Most of the funds in this category are suitable for long-term investments. The longer time horizon ensures stability and allows the investment to show healthy returns over time. The performance track record of the hybrid category infuses confidence among investors to stay investedin these funds. After all; investors get peace of mind when investing in these funds without worrying about the asset allocation and diversification of their portfolio in the long run.