Equity, debt or a hybrid instrument — what should you offer investors?
What is a Hybrid Fund?
Hybrid funds invest in both debt and equity instruments to achieve diversification and avoid the concentration risk. A perfect blend of the two offers higher returns than a regular debt fund while not being as risky as equity funds. The choice of a hybrid fund depends on your risk preferences and investment objective.
How Do Hybrid Funds Work?
Hybrid funds aim to achieve wealth appreciation in the long-run and generate income in the short-run via a balanced portfolio. The fund manager allocates your money in varying proportions in equity and debt based on the investment objective of the fund. The fund manager may buy/sell securities to take advantage of market movements.
Who Should Invest in Hybrid Funds?
Hybrid funds are considered a safer bet than equity funds. These provide higher returns than genuine debt funds and are popular among conservative investors. Budding investors who are willing to get exposure to equity markets may invest in hybrid funds. The presence of equity components in the portfolio offers the potential to earn higher returns. At the same time, the debt component of the fund provides a cushion against extreme market fluctuations.
In this way, you receive stable returns instead of a total burnout that may happen in case of pure equity funds. For the less conservative category of investors, the dynamic asset allocation feature of some hybrid funds becomes a great way to enjoy the best out of market fluctuations.
Types of Hybrid Funds
Hybrid funds are further classified based on their asset allocation. Some hybrid funds have a higher equity allocation, while others allocate more towards debt. Let’s have a look in detail:
Equity-oriented hybrid funds If the fund manager invests more than 65% of the fund’s assets in equity and the rest in debt and money market instruments, then it’s called an equity-oriented fund. The equity component of the fund comprises of equity shares of companies across industries such as FMCG, finance, healthcare, real estate, automobile, and so on.
Debt-oriented balanced funds A hybrid fund is termed as a debt-oriented fund if the fund manager allocates more than 65% towards debt instruments. The debt component of the fund constitutes the investment in fixed-income havens such as government securities, debentures, bonds, treasury bills, and so on. For the sake of liquidity, some part of the fund would also be invested in cash and cash equivalents.
Monthly Income Plans These are hybrid funds that invest predominantly in debt instruments. A monthly income plan (MIP) would generally have 15-20% exposure to equities. This would allow it to generate higher returns than regular debt funds. MIPs provide regular income to the investor in the form of dividends. Investors can choose the frequency of dividends payout; it can be monthly, quarterly, half-yearly, or annually. MIPs also come with the growth option – they let the investments grow in the fund’s corpus. Hence, an MIP is not a small monthly income investment. Do not let the name mislead you. They are hybrid funds that invest mostly in debt and some amount of equities.
Arbitrage Funds An arbitrage fund manager tries to maximise returns by buying the stock at a lower price in one market. He then sells it at a higher price in another market. However, arbitrage opportunities are not always available quickly. In the absence of arbitrage opportunities, these funds might stick to debt instruments or cash. By design, arbitrage funds are relatively safer, like most debt funds. But its long-term capital gains are taxable like that of any equity fund.
Things an Investor Should Consider
Risk factor It would not be wise to assume hybrid funds to be completely risk-free. Any instrument which invests in equity markets will have some risk. It might be less risky than pure equity funds, but you need to exercise caution and portfolio rebalancing regularly.
Return Hybrid funds don’t offer guaranteed returns. The performance of underlying securities affects the Net Asset Value (NAV) of these funds. So, it may fluctuate due to market movements. Moreover, these might not declare dividends during market downturns.
Cost Hybrid funds would charge a fee for managing your portfolio, which is known as the expense ratio. Before investing in a hybrid fund, ensure it has a low expense ratio than other competing funds, and this translates into higher take-home returns for the investor.
Investment Horizon Hybrid funds may be ideal for a medium-term investment horizon, say five years. If you want to earn a risk-free rate of return, you may go for arbitrage funds. They bet on price differentials of securities in different markets.
Financial Goals You can meet intermediate financial goals like buying a car or funding higher education with hybrid funds. Retirees too invest in balanced funds and go for a dividend option to supplement their post-retirement income.
Tax on Gains The equity component of hybrid funds is taxed like equity funds. Long-term capital gains over Rs.1 lakh on equity component are taxed at the rate of 10%. Short-term capital gains (STCG) on equity component are taxed at the rate of 15%. The debt component of hybrid funds is taxable as any other debt fund. You must add these gains to your income and taxed as per your income slab. LTCG from debt component is taxable at 20% after indexation and 10% without the benefit of indexation.
How to Invest in Hybrid Funds?
You can invest in hybrid funds in a paperless and hassle-free manner. Using the following steps, you can start your investment journey.
Mixed Asset Allocation Fund/Multi-Asset Allocation Fund
These hybrid funds invest a minimum of 10% in three or more asset classes. Other than equities and debt, it also includes asset classes like gold, other commodities or REITs. With more assets in the mix, it further diversifies your risk.
Monthly Income Plans
With a focus on fixed income securities, a monthly income plan (MIP) will typically limit equity exposure to 15-20%. The goal of MIPs is conservative investments to generate steady income for the investor while focusing on capital preservation. Investors can choose from monthly, quarterly, semi-annual, or annual dividend payout. You can also look for plans with a growth option, allowing investments to grow in the fund’s corpus.
This type of hybrid fund generates returns on the investment by exploiting the price differential between the cash and derivatives markets. The fund manager will typically buy in the cash market and almost simultaneously sell in the futures market thereby limiting risk. The asset allocation is chiefly towards equities with debt investment not exceeding 35%.
Given that the buy and sell transaction of the security is executed simultaneously, the gains or losses are locked in immediately. This reduces volatility of equity and gives more steady debt-like returns.
Arbitrage funds are a low risk strategy that many large corporations use to deploy excess cash in. On the flip side, arbitrage opportunities are not always easily available. In such cases, the fund manager may choose to allocate part of the funds in debt instruments and cash.
In a balanced fund, debt and equity are mixed in specific proportions. These are typically equity-oriented with 40% to 60% equity allocation. These are seen as low-risk investments with healthy capital appreciation.
Dynamic Asset Allocation Funds
Also known as Balanced Advantage Fund, these funds have the dynamism of moving anywhere from 100% allocation in equity to 100% in debt. Fund managers determine the exposure to the different asset classes depending on prevailing market conditions and their reading of how it will move in the coming days.
Typically, they use some statistics on what the current valuation levels are of the equity market and compare them to historical averages. If the current valuations are seen as low, they increase the weightage to equity and if they are seen as high, they decrease the equity weightage.
Who Should Invest in Hybrid Funds?
Hybrid funds are ideal for investors with a low risk profile. They can opt for debt-oriented, MIPs, or arbitrage funds to ensure regular returns with low risks. On the other hand, investors who wish to invest more in equities can go for equity-oriented hybrid funds/equity hybrid fund/equity savings fund.
Hybrid funds are particularly suitable for first-time investors, limiting their exposure to equity and providing adequate security against fluctuating share prices. It allows them to learn the behavior of the equity market while limiting their risk exposure.
Why Should You Invest in Hybrid Funds?
Hybrid funds offer many benefits, providing investors a balanced medium to start with.
Balancing risks with returns
The main advantage of a hybrid mutual fund is that it allows investors to strike the right balance between the risk and return. When compared to pure equity funds, hybrid funds offer the stability of stable assets like debts. It allows investors to experiment with high-return equity investments by cushioning them with more predictable returns on their debts. Arbitrage funds can further lower the risks of the equity component.
A hybrid fund diversifies risks as it combines both equity and debt. By parking our money in different assets, we minimize the exposure of risk in any single asset class. Hence, any fluctuations in the equity market can be offset by returns from the debt instruments. Mixed asset allocations further diversify risks by distributing it in other markets, such as commodities.
Equity funds are subject to market volatility. In a volatile market, hybrid funds can help you manage it in a flexible manner. For instance, the quick sale through an arbitrage hybrid fund ensures that volatility has no impact on your returns.
Things Investors Should Consider Before Investing
Even though it is seen as a safe option, it would be a mistake to assume that hybrid investments are entirely secure. In a hybrid fund, the risk typically stems from its equity portion and one must always consider the investor’s risk profile when deciding the proportion of the equity. Additionally, it would be a mistake to see debts as completely secure. Even debt instruments like government securities involve a risk of some degree.
In a debt-oriented hybrid fund, risk is defined by whether we are looking for capital gains or interest income. Gains from price appreciation can be riskier than returns from interest income of debt-oriented funds.
The returns on a hybrid fund or its net asset value (NAV) is determined by its underlying securities’ performance. For instance, the returns on an equity-oriented fund will be largely subject to equity market fluctuations.
Like all mutual funds, hybrid funds also entail a fee, known as expense ratio. While a lower ratio typically means higher returns, not every high expense ratio fund translates into low returns. Conduct your due diligence and evaluate the overall cost in terms of expected returns.
Hybrid investments are generally meant for medium-term investment of up to five years. The longer time horizon ensures stability and allows the investment to show healthy returns over time.
Like any other investment, it is important to assess your financial goals before you invest in a plan. Your financial goal will determine your risk tolerance and your expected returns. For instance, an elderly investor looking for retirement income may choose a more stable debt-oriented fund. It is always advisable to share your goals with your fund manager for the right asset allocation.
Capital gains tax on hybrid or balanced funds depends on the equity exposure, which if exceeds 65% is taxed similar to an equity fund else like a debt fund, making it an important aspect to learn about your fund.
One of the most critical aspects of prudent investment is risk diversification. Hybrid funds by their very nature allow us to follow diversification in different asset classes, avoiding concentration in one class or industry. This is why it has emerged as one of the safest means of investment, especially for those with a low risk profile.