Why you need to have hybrid mutual funds in your portfolio: Misconceptions Part 1

Mutual funds are increasingly getting popular among retail investors in India. In the last 20 years, as per AMFI data, mutual fund industry assets under management (AUM) grew at a compounded annual growth rate of 19%. AUM mobilization has gained even more momentum in the last 5 years with industry AUM growing to over Rs 26 lakh Crores as on 31^st October 2019. For retail investors however, mutual funds are still largely seen as equity investments.

As per AMFI data, industry AUM in equity funds is more than Rs 7.5 lakh Crores. Equity oriented schemes comprise nearly 70% of retail investor AUM. However, even though equity is the popular asset class for retail mutual fund investors, it still comprises a relatively small proportion of the average household savings in India. By and large, households in India prefer the safety of fixed income. This is a dichotomy and an asset category which combines the best of both worlds, stability (low volatility) of fixed income and superior returns of equity, can be ideal investment solutions for wide spectrum of investors.

What are hybrid mutual funds?

Hybrid mutual funds are a class of mutual fund schemes which invest in multiple asset classes, primarily fixed income and equity, also gold and real estate. There are different types or categories of hybrid mutual fund schemes with different asset allocation profiles and investment strategies, which provide investment solutions for a wide range of risk capacities and investment needs. The hybrid mutual funds category has also grown in popularity over the last few years, with a total AUM of Rs 3.5 lakh Crores.

However, many investment experts feel that the growth potential of hybrid mutual funds is much more than what we have seen so far. Further, we have seen redemptions in this category of funds in 2019. We saw investors flocking to hybrid funds in bull markets, but we in Advisorkhoj, feel that investors get confused in mixed market conditions. Based on our interaction with investors and financial advisors, we think that there are many misconceptions and lack of correct awareness of hybrid funds, which we will try to address in the first part of this multi-part blog posts.

Financial advisors play a very important role in distribution of mutual funds and unfortunately, many advisors are not able to articulate the correct positioning of these funds in context of investor needs resulting in confusion and wrong perceptions. We hope that our advisor community, who play such an important role in investor awareness, will be able to clarify doubts, set the right expectations and explain why these funds deserve an important place as far as investor’s overall savings are concerned.

Correcting misconceptions about hybrid mutual funds

• Hybrid funds are not equity funds:

  Many investors think that hybrid funds are akin to equity funds and expect the similar returns from them. In good times, some hybrid funds like aggressive equity oriented hybrid funds can give equity like returns, but investors need to understand the relationship between risk and return. Higher returns come only with higher risks. Hybrid funds have a lower risk profile than equity funds. So in some market conditions, hybrid funds will underperform equity funds while in different conditions, they will outperform equity funds. You should invest as per your risk appetite and form expectations accordingly. Your expectations should not be based on past point to point performance but on your asset allocation or risk profile of your investment
  
  Suggested reading: Return expectations from mutual funds – how important is past performance



• Hybrid funds are not risk free:

  The other extreme is the perception that hybrid funds do not have any risk. Investors think that, hybrid funds will give high returns in good market and at the same time, will protect their money in falling market. It is true that, hybrid funds capitalize on equity returns in the long term and limit downside risks in the short term, but you have to be prepared for volatility in the short term when you are investing in hybrid funds. The difference between equity and hybrid funds is the relative volatility. Equity funds are much more volatile than hybrid funds. You can compare the draw down in equity funds and hybrid funds in deep market corrections and you will understand the difference in risk characteristics of the two funds. It is all in the degrees of risk and you need to educate yourself / your investors on it in order to make informed investment decisions. If for whatsoever reason, you need to redeem equity fund in a deep market correction, you will suffer much greater loss compared to redemption from hybrid funds.



• Hybrid mutual funds do not give assured cash-flows:

  This perception has been caused by several hybrid funds giving regular monthly dividends over the last few years. In the last few years, many investors, especially senior citizens invested in these schemes to get superior tax efficient regular income. In our blog, we have repeatedly flagged off this expectation of monthly dividends as a concern. There is no guarantee of regular dividends in mutual funds. Mutual fund dividends are paid from the accumulated profits reserve of a scheme. If accumulated profits are not growing due to market conditions, a scheme paying monthly dividends will deplete the accumulated profits reserve and in the end, may not be able to sustain regular monthly dividends or may be forced to reduce their dividend pay-out rate. Mutual fund dividends, as stated a number of times in our blog, should be a supplementary source of income, not your regular income source.



• Equity will not always outperform fixed income:

  Even many experienced mutual fund investors believe that, equity funds will always give out sized returns compared to debt. However that is not always the case. In this last one year several debt fund categories outperformed many equity fund categories (please see mutual funds category monitor).There have been several time periods in the past, when fixed income or debt outperformed equity; some of this time periods have been quite long, up to 3 years. Different asset classes outperform or underperform each other depending on market and macro-economic conditions. Periods of outperformance / underperformance varies depending on prevailing market conditions. Hybrid funds reduce volatility and provide stability across different market conditions over varying time periods, providing optimal risk adjusted returns over sufficiently long investment tenure.



• All hybrid mutual funds are not balanced funds:

  This is one of the biggest misconceptions. Balanced funds are among the oldest categories of hybrid funds; the oldest balanced funds in our country are nearly 25 years old. Naturally the balanced funds category is one of the most popular sub-categories of hybrid funds, comprising nearly 40% of the hybrid fund’s industry AUM. We need to clarify several misconceptions here.


• Firstly, balanced funds, as the name implies, can be wrongly perceived to be balanced in terms of asset allocation. However in reality, due to tax treatment compulsions, balanced funds are essentially aggressive equity oriented hybrid funds with 65 to 80% allocation to equities. You can therefore understand that balanced funds are not all balanced; they have a strong equity bias and you should be prepared for the risks thereof.


• Secondly, there are several other hybrid funds sub-categories which have different risk and asset allocation profiles compared to balanced funds. These sub-categories were formalized by SEBI, in their mutual fund re-classification and rationalization circular to AMCs. Different hybrid fund sub-categories provide a variety of investment solutions for different investment needs. If you match the solutions with your requirements, then they can be great investments suited for your specific needs. We will discuss more about these in the second part of this blog post.


• Thirdly, all hybrid funds are not risky due to their equity exposure. Some hybrid funds like conservative hybrid funds and arbitrage funds have 75 – 80% exposure to fixed income or arbitrage. These funds are more like debt funds with some equity upside in the long term or beneficial tax treatment compared to debt funds depending on the type of fund.


• Finally, asset allocation is not just about fixed income and equity. There is a sub-category of hybrid funds known as Multi Asset Hybrid Fund, which invests in other asset classes like Gold and Real Estate. You can get exposure to different asset classes by investing in these schemes, without having to worry about how much to invest where and rebalancing your investments from time to time.


• You may like to read this fund review of a multi asset hybrid fund – A good scheme in uncertain times

Conclusion

The mutual fund industry in India has matured tremendously in the last 25 years or so. One category of mutual funds which deserves more attention and awareness in the Indian retail context is the hybrid mutual funds category. We, in Advisorkhoj are committed to raising awareness about investments and mutual funds in particular. In this blog post, we discussed several misconceptions about hybrid mutual funds and hope to clarify doubts which investors may have.

In case you have some misconceptions about mutual fund investments in general, we suggest you to read this Are you still not investing in mutual funds due to misconceptions

In our subsequent posts, we will explain different types of hybrid funds and why it deserves an important place in your investment portfolio. Please stay tuned.......