A complete guide to Hybrid Mutual Funds

Let us explore and understand hybrid mutual funds in detail.

October 17, 2019 8:13 IST | India Infoline News Service
Considering the volatility in stock markets, the one piece of advice we tend to get from equity advisors is to continue investing in mutual funds through SIPs. In fact, most advisors will tell you to enhance your contributions in equity funds. However, many of us are a little wary to expose our funds to the volatility of the stock markets, even if it is through mutual funds.  Hybrid funds are a perfect investment option in such a scenario. Let us explore and understand hybrid mutual funds. 

What are hybrid funds?
Hybrid or balanced funds invest in more than one asset class-the more common ones being a mix of equity and debt. The debt portion comprises of fixed income instruments, government bonds, corporate debentures, treasury bills, etc. The ratio of debt to equity is based on the scheme’s objective. These funds combine the compounding potential of equity assets with the relative stability of debt assets. They are, therefore, better suited for investors with a moderate risk appetite.

When you invest in a mutual fund, you could have either of two objectives i.e. capital protection or capital appreciation. Hybrid funds also known as balanced funds offer a combination of both. The debt portion ensures that the value of the capital is protected against inflation. The equity portion provides some amount of capital appreciation. Based on which of the two markets have a higher allocation, hybrid funds are classified in the following categories by Securities and Exchange Board of India (SEBI):
  • Aggressive
  • Balanced
  • Conservative
  • Multi asset allocation
  • Dynamic asset allocation
  • Arbitrage
  • Equity saving funds

Types of hybrid mutual funds:
There are various types of hybrids funds available to cater different needs of an investor. For example, an aggressive hybrid fund has higher exposure to equity instruments for achieving greater tax efficiency whereas a conservative hybrid fund will have higher exposure to debt instruments with an aim to provide relatively higher return than traditional saving instruments through a small exposure to equity. Broadly however, hybrid funds can be catalogued in the following manner:
  • Equity hybrid funds: These funds invest more than 65% of their asset allocation in equities and the balance in debt. This ratio can vary but typically, the fund manager will not allow the equity proportion to go below the 65% mark. That is because 65% exposure to equity is the bare minimum requirement for be classified as an equity fund for tax purposes.
  • Debt hybrid funds: Here the predominant exposure is in debt. This type of fund will have around 75-80% in quality debt paper and the balance will be invested in equities. For tax purposes, the MIP will be classified as a non-equity fund but the small equity exposure enables the company to earn Alpha. Being predominantly debt oriented, the MIPs are also very useful for retirees who can afford to take slightly higher risk on their investments for higher returns.
  • Arbitrage funds: In these types of funds, the fund manager buys a portfolio of equities and sells equivalent futures against that. The spread is the profit and it is like earning interest. The returns on these arbitrage funds vary from 6-8% per year depending on the spreads in the market. Since futures are leveraged products, these funds are classified as equity funds due to predominant exposure in equities and get preferential tax treatment. This makes them more attractive compared to other fixed income instruments.

Benefits of hybrid funds:
  • 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 ensure stability and lower risk.
  • The other major advantage hybrid funds provide is diversification across asset classes. This helps as it tends to be insulated from sudden euphoria or panic situations that usually investors are generally susceptible to with pure equity or debt funds.
  • Hybrid funds are especially suitable for first-time investors, especially in terms of exposure to the stock markets. They will get to experience the dynamism of equity markets without partaking in majority of the risk.
  • Investors have the option to switch from one combination of assets to another that may offer more opportunities growth-wise. Changes can be made with the fluctuations occurring due to market conditions.
Disadvantages of hybrid funds:
  • Hybrid funds are not risk free. There are two kinds of risk involved in a balanced or hybrid mutual fund – fluctuations in stock prices and interest rates.
  • It is very difficult to link a financial goal to a hybrid fund as it can take the characteristics of equities or debt switch between the two across the investing lifetime.
  • Supervising debt and equity require differing skill sets, and managers of hybrid funds may not be proficient at handling both asset classes. This could lead to sub-optimal returns for investors.

Who should invest in hybrid funds?
  • Hybrid Funds are suitable for investors who want the growth of equity with safety of debt funds. Investors who are new or are vary of market fluctuations could consider investing in them as they seek to generate returns comparable to equity, at lower risk as compared to pure equity funds.
  • For retired persons looking at regular income with a slightly higher risk and return, hybrid funds can provide an ideal investment haven. They can choose ones which are predominately debt funds which brings stability. However, a small 15-20% of the allocation is made to equities and that results in a small alpha over pure debt funds.
  • For investors who do not wish to manage the asset allocation of their portfolio themselves, hybrid funds could be a very enticing option.
  • Investors who would like to park their surplus funds for 3-4 years, and want to receive higher potential returns in comparison to liquid or debt funds can look at hybrid funds as a viable option.

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