What are Hybrid Mutual Funds?

As the name suggests, Hybrid funds are a combination of equity and debt features into a single fund. The idea is to get the best features of equity and debt into a single fund, although it does not always work that way. Actually, hybrid funds are about tweaking risk.

For example, not everyone wants to invest in high-risk, high return mutual funds. At the same time, those with a higher risk appetite wouldn't want to invest all of their money in low-risk low return debt funds. To cater to investors with a risk appetite that is neither high nor low, the third type of mutual fund exists; called hybrid mutual fund.

So, What exactly is a hybrid funds?

A hybrid fund tries to give the investor the best of both worlds - it is neither too risky, nor it is too low on returns. Unlike an equity fund that invests only in equity securities or a debt fund that will only invest in bonds, a hybrid mutual fund diversifies the portfolio while minimizing risk by investing in both equity and debt securities.

However, even hybrid funds have classifications. For example, if you are aggressive investor wanting little bit of stability then equity balanced funds (Aggressive Hybrids) could be the answer. If you are a conservative investor looking to get that little bit extra through equity funds then MIPs or monthly income plans (Conservative Hybrids) could be the product for you. Here is how hybrid funds like equity balanced funds and MIPs help fill a gap in the mutual funds market.

What are the different types of hybrid funds that are availabe? 

The AMFI definition classifies hybrid funds in India into the following key categories as under:

• Aggressive Hybrid
• Balanced Hybrid
• Conservative Hybrid
• Equity Savings Funds
• Arbitrage Funds
• Multi Asset Allocation
• Balanced advantage funds (dynamic allocation)

The Balanced advantage funds have been extremely popular in recent times with stellar response to the recent NFOs of SBI Mutual Fund and NJ Mutual Fund.

The aggressive hybrid funds are invested predominantly in equities to the tune of 70-75% with the balance in debt. The AUM of the aggressive funds in India around Rs.143,000 crore and has been growing quite rapidly.

These aggressive hybrid funds are meant for equity investors looking to hedge some of their risks by adding debt to their portfolios.

The conservative hybrid funds are invested predominantly in debt to the tune of 80-85% with the balance in equity. The AUM of the aggressive funds in India around Rs.19,000 crore and has been stagnating in the recent past due to low returns on debt funds.

Hybrid funds (equity balanced) have attracted investors because of the favourable tax treatment given to equity balanced funds. For example, balanced funds with a minimum exposure of 65% to equities are classified as equity funds. This gives them preferential treatment in taxation of short term and long term capital gains.

Capital gains on a debt fund are classified as short term if held for less than 3 years and taxed at the peak incremental rate. If you hold the debt funds beyond a period of 3 years then it becomes long term capital gains and is taxed at 20% with the benefit of indexation. On the other hand, Aggressive Hybrid Fund capital gains are treated long term if held for more than just 1 year. Even short term gains on aggressive hybrid funds are taxed at a concessional 15%. Long term gains on equity were tax-free till Union Budget 2018. However, from April 2018, equity capital gains attract LTCG tax at the flat rate of 10% without the benefit of indexation, beyond the basic exemption limit of Rs.1 lakh.

Effective the 2020 budget, all dividends are taxable as other income in the hands of the investor.

We will not count arbitrage funds, despite the SEBI classification, due to it being purely a treasury product. In the hybrid category, there are three sub-classifications that investors can look at.

1. Equity balanced fund typically has a 75-80% exposure to equity and the balance to debt. A balanced fund typically tends to keep its exposure to equity and debt fairly static to get the full tax benefits of an equity fund. Equity oriented balanced fund are attractive due to tax benefits on par with equity funds.
2. A dynamic fund has the leeway to switch equity/debt mix aggressively. There are times Dynamic Funds tend to outperform the balanced funds but it is more aggressive in nature and therefore riskier. A dynamic fund can go to 100% in debt and 0% in equity and vice versa depending on their view. That is the risk, that there is too much of discretion to the fund manager in a dynamic equity plan.
3. Finally, conservative hybrids or MIPs have a larger exposure to debt and a smaller exposure to equity. MIPs do not get the tax benefits on capital gains; hence they tend to be structured as monthly income plans to avoid the tax on capital gains. These monthly pay-outs are normally structured as SWPs to minimize the tax impact.