How different hybrid funds help in asset allocation

Hybrid funds are mutual fund schemes which invest in multiple asset classes e.g. equity, fixed income, gold, real estate investment trusts (REITs) etc. The main benefit of hybrid funds is asset allocation. Asset allocation diversifies investment risk by spreading the investment of two or more asset classes. The risk profile of a hybrid fund depends on the asset allocation of the scheme.

Categories of Hybrid Funds

There are different types of hybrid funds with different asset allocation profiles. SEBI has categorized hybrid funds in the following categories:-

• Aggressive hybrid funds: These hybrid funds invest 65 - 80% of their assets in equity and equity related securities and 20 – 35% of their assets in debt and money market instruments. In terms of risk profile, these funds are the most aggressive compared to other hybrid funds.


• Balanced hybrid funds: These hybrid funds invest 50% of their assets in equity and equity related securities and 50% of their assets in debt and money market instruments. An AMC is allowed to offer either aggressive or balanced hybrid fund, but not both.


• Dynamic asset allocation funds: Also known as Balanced Advantage Funds, these funds dynamically manage their asset allocation; there is no upper or lower limit for equity or debt allocations. Dynamic asset allocation or balanced advantage funds are usually less volatile than aggressive hybrid funds.


• Equity savings funds: These hybrid funds can partially hedge their equity allocation using derivatives, while maintaining gross equity allocation of at least 65%. These funds must invest at least 10% of their assets in debt and money market instruments. Equity savings funds must mention their minimum hedged and un-hedged equity exposures in their Scheme Information Documents (SIDs). A big advantage of equity savings funds is that they enjoy equity taxation even with fairly low net long equity exposures because of the arbitrage component.


• Multi asset allocation funds: These hybrid funds can provide exposure to three or more asset classes e.g. equity, debt, gold, real estate investment trusts (REITs) and infrastructure investment trusts (InvITs). Multi asset allocation funds must invest at least 10% each in three asset classes e.g. minimum 10% in equity, minimum 10% in debt and 10% in gold.


• Conservative hybrid funds: These hybrid funds invest 75 - 90% of their assets in debt and money market instruments and 10 – 25% of their assets in equity and equity related securities. These funds can be suitable for investors with moderately low to moderate risk appetites and at the same time get equity kicker for inflation adjusted returns.


• Arbitrage funds: These hybrid funds can fully hedge their equity exposure using arbitrage strategy. Arbitrage funds must maintain gross equity allocation of at least 65%. Maximum investment in debt and money market instruments is capped at 35%. These funds are suitable for parking your surplus funds for a few months since the risk is low. The main advantage of these funds compared to liquid or ultra-short duration debt funds is that arbitrage funds enjoy equity taxation.

Why invest in hybrid funds?

• Risk diversification: Different asset classes e.g. equity, fixed income, gold etc have different investment cycles. There is low or even negative correlation in returns of two or more asset classes. The chart below shows the annual returns of different asset classes viz. equity (represented by Nifty 50 TRI), fixed income (represented by Nifty 10 year benchmark G-Sec index) and Gold. You can see in the chart below that equity and gold are usually counter-cyclical to each other, i.e. Gold outperforms when Equity underperforms and vice versa. Further there is low correlation between fixed and the other two asset classes. Diversifying your portfolio across asset classes limits downside risk when a particular asset class underperforms.
  
  

  Source: National Stock Exchange, Advisorkhoj Research. Period: 01.01.2011 to 31.03.2022. Equity is represented by Nifty 50 TRI and fixed income is represented by Nifty 10 year Benchmark G-Sec Index. Disclaimer: Past performance may or may not be sustained in the future.



• Portfolio Rebalancing: Hybrid funds provide the benefit of periodic portfolio rebalancing. Rebalancing of assets ensures that the asset allocation of your investments do not deviate from the targeted asset allocation despite market movements. Portfolio rebalancing is aimed to reduce risk and help in generating relatively better risk adjusted returns over sufficiently long investment tenures. Please note that different funds follow different rebalancing strategies. You should read the scheme information document before investing.


• Tax efficiency: Hybrid funds can be much more tax efficient compared to a portfolio of equity and debt schemes. Hybrid funds whose average gross equity allocation (including hedging or arbitrage) is more than 65%, enjoy equity taxation.

Taxation of hybrid funds

Note: Investors should consult with their financial advisors about the taxation of their hybrid scheme before investing.

Points to consider before investing

• Different hybrid funds have different asset allocations and risk profiles. You should always invest in the appropriate hybrid fund category according to your risk appetite and investment needs. Consult with your financial advisor, if you need help in understanding your risk appetite.


• Investors should understand that different schemes within the same hybrid funds category may have different risk profiles. You should refer to the scheme Riskometer to understand the risk at the scheme level.


• Different hybrid funds have different tax consequences. You should know the tax consequence of your investment and make informed decisions. However, in our view, one should not make investment decisions based on only tax considerations; your financial goals and risk appetite are more important factors.


• Since hybrid funds are less volatile than equity funds, they may be suitable for new investors. However, you should always have long investment horizons (e.g. 3 years or longer) for hybrid funds (except arbitrage funds).


• You should always consult with your financial advisor if you need help in understand the risk / return characteristics of a hybrid scheme.