Hybrid Funds

Hybrid funds or Hybrid Mutual funds are a combination of equity and debt mutual funds which invest in a diversified portfolio of both equity and debt securities. People who have a moderate risk appetite and are looking for a diversified portfolio should invest in hybrid funds rather than several individual securities.

To meet the risk profile of various investors, hybrid funds are further classified into equity-oriented hybrid and debt-oriented hybrid funds, depending on their exposure. If equity exposure is over 65%, then it is said to be an equity-oriented hybrid fund. If not, it is a debt-oriented fund.

Hybrid funds are ideal for investors looking for a combination of capital protection as well as wealth creation.

• Higher returns than FD

  
  

  Hybrid funds are a mixture of two asset classes- equity and debt. Equity has the potential to generate good returns, while debt funds add stability to the portfolio, and protect from financial losses in case of a downturn in the equity market. The combined portfolio will generate a higher return compared to traditional instruments like fixed deposits and liquid funds.

• Lower risk

  
  

  Equity offers a higher return but carries higher risks in terms of market fluctuations, i.e., volatility. Whereas debt instruments offer lower returns, but the risk is also significantly low. The combined portfolio offers lower volatility compared with individual equity funds.

• Stability

  
  

  Hybrid funds were created to provide stability to the investors. Equity is a high-risk instrument, and the returns are volatile. On the other hand, debt is a low volatile asset class with stable returns. This means the combined portfolio will create stability in terms of returns, as well as reduce risk.

• Access to multiple assets

  
  

  Hybrid mutual funds provide access to multiple asset categories through a single fund, eliminating the need for multiple individual investments. This simplifies investors’ investment management by consolidating various asset classes within a single investment vehicle.

• Diversified portfolio

  
  

  Hybrid funds in India offer enhanced portfolio diversification. These funds not only diversify across different asset classes but also across sub-classes within each class. This means they can spread investments across various categories such as large-cap, mid-cap, or small-cap stocks, as well as value or growth stocks. This broader exposure to different market segments reduces the impact of any individual investment thus lending investment safety.

• Active risk management

  
  

  Best hybrid funds employ portfolio diversification and asset allocation strategies to actively monitor and mitigate portfolio risk. They minimize the impact of market volatility by investing in non-correlated asset classes such as equity and debt. This active risk management approach helps investors to safeguard their capital during turbulent market conditions.

• Caters to multiple risk profiles

  
  

  Hybrid funds cater to investors with varying risk preferences - conservative, moderate, or aggressive. They align with investors having different risk appetites and investment goals.

Hybrid mutual funds are ideal for novice as well as experienced investors. They are particularly beneficial for:

• First-time investors

  
  

  Hybrid funds are ideal for novice investors who are just starting on their investment journey and prefer the stability of fixed-income instruments but also understand the growth potential of equity. These funds offer an entry point to the equity market while allowing investors to choose a subtype that aligns with their risk tolerance.

• Investors having a medium-term investment horizon

  
  

  Hybrid mutual funds are suitable for investors having a 3-5 year investment horizon that caters to a specific goal in mind such as purchasing a house. Such investors often seek growth but with reduced volatility. Hybrid funds are a good option for such investors as they provide portfolio balance by investing in both debt and equity, resulting in relatively lower volatility compared to pure equity funds.

• Retired Individuals

  
  

  Retirees who rely on regular income to meet their financial needs can find conservative hybrid funds suitable. Because of a combination of debt and equity exposure, hybrid mutual funds can generate consistent income through the debt component and potentially higher returns through equity to counter inflation during retirement

• Investors seeking asset allocation

  
  

  Hybrid funds are also ideal for investors who desire a well-diversified investment portfolio but lack the time or expertise to actively manage it. These funds offer ready-made investment portfolios with a predetermined asset allocation, simplifying the investment process for such investors.

• Investors having a short-term investment horizon

  
  

  For investors seeking a tax-efficient option to allocate funds during periods of market volatility with a minimum investment horizon of at least six months, a category of hybrid funds i.e. arbitrage funds are well-suited.

Hybrid mutual funds in India primarily invest in two asset classes – equity and debt.

The equity component is known to carry higher volatility risk in the shorter term but at the same time has the potential to offer good returns and build significant wealth. The debt component comprises of interest-bearing instruments that have the potential to generate regular income and are known to carry lower risk compared to equity. Hybrid funds work towards reducing portfolio risk by investing in a combination of equity and debt instruments. This allows them to offer the best of both asset classes, with the potential for high returns from equities and the stability of debt.

The equity portion of a hybrid fund invests in equity markets, which can provide high returns over the long term. The debt portion of a hybrid fund invests in bonds, which are less volatile than stocks and provide a regular stream of income.

The fund manager of a hybrid fund typically adjusts the asset allocation between equity and debt based on the market outlook. When the market is doing well, the fund manager may increase the allocation to equity. When the market is underperforming, the fund manager may increase the allocation to debt.

Hybrid funds can be classified into the following types based on their asset allocation between equity and debt:

• Hybrid equity funds

  
  

  Equity-oriented hybrid funds invest a minimum of 65% of their assets in equity and equity-related instruments. Hybrid equity funds typically invest in companies from different market capitalizations and sectors. The remaining 35% of the fund's assets are allocated to debt securities and money market instruments.

• Hybrid Debt funds

  
  

  Debt-oriented hybrid funds invest a minimum of 60% of their assets in fixed-income securities such as government securities, debentures, bonds, etc. The remaining 40% of the fund's assets are allocated to equity instruments. They may also choose to invest an insignificant portion of their corpus in liquid schemes.

• Balanced Funds

  
  

  Balanced funds invest a minimum of 65% of their assets in equity and equity-related instruments. The remaining corpus is invested in debt securities and cash. From a taxation perspective, these funds are categorized as equity funds and provide tax exemption on long-term capital gains of up to Rs. 1 lakh. The presence of a fixed-income component makes them an attractive choice for equity investors as it helps reduce the volatility associated with equity investments.

• Arbitrage Funds

  
  

  Arbitrage funds are a type of hybrid funds that generate returns by deploying the strategy of simultaneously buying and selling of securities in different markets with the aim of maximizing the fund’s returns. In simple words, they buy stocks at a lower price in one market and sell them at a higher price in another to make gains.

• Dynamic Asset Allocation Funds

  
  

  These schemes can shift between 100% debt to 100% equity asset class. These funds invest in multiple asset classes and adjust investment allocation based upon market conditions. This means that if the fund manager has reasons to believe that the equity market does not offer a good potential return, the asset allocation will be diverted from equity to debt or other asset classes. The allocation will be reversed if the fund manager is bullish on equity.

• Multi-Asset Allocation Funds

  
  

  The fund manager invests in multiple asset classes like equity, debt, real estate, gold, etc. These schemes need to have investments in at least three asset classes with a minimum of at least 10 percent in each of the asset classes.These funds are an ideal fit for a diversified portfolio. The overall risk exposure is reduced due to multi-asset diversification.

• Risk Profile

  
  

  Hybrid funds carry more risk than debt funds but are less risky than equity funds. The risk depends upon the proportion of equity holding in the portfolio. The higher the equity holding, the riskier the fund. Therefore, if you are a conservative investor with a low risk-bearing capacity, you may select a hybrid conservative fund or hybrid balanced fund. On the other hand, if you are an aggressive investor with a high risk-bearing capacity, you may select an aggressive hybrid fund.

• Investment Horizon

  
  

  For investors with medium-term investment horizons, such as 3 or 5 years, hybrid funds that allocate a larger portion to equities have the potential to generate substantial returns. On the other hand, for those with shorter time horizons, hybrid funds with a higher allocation to debt are favoured. This is because, in the short term, equity investment may be subject to volatility but debt investment will be less volatile and will continue to provide stable returns.

• Investment Cost

  
  

  Similar to other mutual funds in India, hybrid funds also charge a fee known as expense ratio which is generally around 0.5 to 1.5 percent. It includes management fees and operational costs. A lower expense ratio is better for investors as it indirectly translates to more returns.

• Taxability

  
  

  The taxation of capital gains in hybrid funds is determined by their fund allocation model or type. It is important for investors to be aware of the specific type of hybrid fund they are considering to invest in, as this knowledge can assist in optimizing tax planning. When a hybrid fund invests 65% or more of its portfolio in equity, it is taxed as an equity fund. Conversely, if the fund allocates less than 65% to equity, it is taxed as a debt fund.

• Track record

  
  

  When a fund consistently surpasses its peers and the benchmark over a 3-5 years period, it suggests effective management. While past performance does not guarantee future returns, it serves as a significant indicator of the fund's track record and aids in evaluating its performance in comparison to similar funds.

• Management

  
  

  The performance of the best hybrid mutual funds relies significantly on effective management. Therefore, if you have faith in the asset management company and its ability to foster growth, you can rely on the fund. It is also crucial to consider the reputation of the fund manager before taking any decision.

• Expense ratio

  
  

  The expense ratio is the fee associated with the fund which includes charges for maintenance, marketing, distribution, and selling. An expense ratio within the range of 0.5% to 2.5% which is an ideal industry benchmark is considered desirable. Consider this while taking a decision.

• Asset allocation

  
  

  Before investing, you may want to assess how diversified is your fund’s portfolio and how is the asset allocation done. While some funds focus on investing more in debt instruments, others focus more on large-caps and mid-caps and some funds focus on a particular sector like pharmaceutical or banking. The choice of the fund becomes important as your risk and return potential can be largely influenced by the asset allocation of the fund.

• Asset Under Management

  
  

  Managing a large fund size can be challenging, while a smaller fund size may lack flexibility. It is important for the asset under management to strike a balance and not be excessively high or low. This enables the fund manager to navigate turbulent times smoothly by easily liquidating investments when needed.

Based on the income tax law, mutual funds are broadly classified into two categories for the ease of computing taxes i.e. Equity Oriented Schemes and Other Schemes.

• Equity Oriented Schemes

  
  

  Equity-oriented hybrid funds primarily invest in equity or equity-oriented securities. The asset allocation in equity is around 65% - 80% and therefore they are categorised as equity-oriented funds. Equity-oriented schemes enjoy tax benefits compared to other schemes.
  
  - Long Term Capital Gains: When equity-oriented hybrid funds are held for a duration exceeding one year, the gains arising from them are treated as long-term capital gains and are taxed at 10%. In a financial year, gains of up to Rs. 1 Lakh are exempt from taxes.
  
  - Short Term Capital Gains: When equity-oriented hybrid funds are held for a duration of less than one year, the gains arising from them are treated as short-term capital gains and are taxed at 15%.

• Other Schemes

  
  

  Funds that are not equity-oriented are classified under other schemes.
  
  Pursuant to amendment to the Finance Bill 2023, any capital gains earned on investments made in these schemes on or after 1 April 2023, will be considered as short-term capital gains and added to the investor’s income and taxed at the applicable income tax slab rates (plus any applicable surcharge and cess), regardless of the investment holding period.
  
  Please note that investments made on or before March 31, 2023, and held for more than 36 months will be eligible for indexation benefit in taxation. Gains on such investments will be taxed at a rate of 20% (plus applicable surcharge and cess) after taking into account the indexation benefit.