All you need to know about Hybrid Mutual Funds: Part 1

For a long period of time, most retail investors in our country associated mutual funds only with equity investments. In Advisorkhoj, we get a large number of mutual fund related queries from investors every week. We have seen that, around 70% of the queries are related to equity mutual funds. However, over the past three years, we have seen a lot of interest in other asset categories like debt funds, hybrid funds etc. This is a very encouraging development because mutual funds can provide solutions to a wide variety of investing needs. A few months back, we published a series on debt funds, to improve knowledge about fixed income investing and awareness of debt fund products. In this series of articles, we will discuss about hybrid funds, their characteristics, benefits and different type of hybrid funds.

What are hybrid funds?

A hybrid fund is category of mutual funds whose underlying portfolio comprises of a mix of equity or equity related securities, debt or fixed income securities and money market instruments. Sometimes hybrid funds can be fund of funds, i.e. a scheme which invests in other mutual fund schemes, but the underlying portfolio of the funds in a hybrid fund of funds will comprise of equity, debt and money market securities. Equity or equity related securities are shares of companies and derivatives (for hedging). Debt securities include Government bonds of varying maturities and corporate bonds (sometimes called non convertible debentures). Money market instruments include Treasury Bills, commercial papers, certificates of deposit etc.

Each of these asset categories (equity, debt and money market) has different risk, return and liquidity profiles. The combined risk / return characteristics of a hybrid fund will be determined by the allocation percentages of each asset category in the fund. Different hybrid funds have different risk / return characteristics depending on the relative proportions of the different asset categories and as such, different types of hybrid funds can provide effective investment solutions for a variety of investment needs and risk capacities.

Asset Allocation in financial planning

We have discussed the importance of asset allocation a number of times in our blog. Asset allocation is the percentage mix of different asset classes like debt, equity, gold etc in your total asset portfolio. However, we have seen that, many investors ignore asset allocation in their investment planning. A sub-optimal asset allocation may compromise your financial planning by putting your goals in danger.

For example, if your asset allocation is heavily weighted towards equity and you are approaching an important financial goal, a sharp downturn in stock market will cause your portfolio to lose a lot of value and may not recover when you need the money. On the other hand, if you are too light on equity and have most of your money invested in fixed income (debt) then you may fall short of your financial objective because fixed income returns may not be sufficient in helping you achieve your goal. Optimal asset allocation enables you to take the right amount of risk and get adequate returns to meet your financial goals.

Optimal asset allocation differs from investor to investor depending on their age, risk capacities and financial situation. Depending on how sophisticated you want to be with your asset allocation, you can have a bespoke asset allocation strategy (working with a financial planner) or follow simple rule based asset allocation strategies. A popular asset allocation strategy is the Rule of 100; simply subtract your age from 100 and the result should the desired equity allocation in your portfolio (the balance allocation will be in debt / money market). So if you are 30 years old, your equity allocation should be 70% and your debt allocation should be 30%.

You can construct this optimal asset allocation portfolio by allocating 70% of your money in equity mutual funds and 30% in debt mutual funds. You need to have good understanding of debt funds in order to select the appropriate fund(s) for your portfolio because different types of debt funds have different risk (interest rate risk and credit risk) characteristics. On an ongoing basis, you have to monitor both equity and debt funds investment performances. From time to time you also need to rebalance your portfolio because your portfolio asset allocation will deviate from the optimal asset allocation over a period of time (we will discuss this in more details later).

Hybrid funds can make asset allocation simpler

If you want to avoid the hassle of managing your equity and debt portfolio yourself, you can invest in a hybrid fund, which has the same (or nearly the same asset allocation). For example, if your optimal asset allocation is 70% equity and 30% debt, you can invest in balanced funds, a type of hybrid fund, which usually has 65 – 75% equity allocation and 25 – 35% debt allocation.

You may like to read Investing in balanced funds versus a portfolio of equity and debt funds

If your optimal asset allocation is 20 - 30% equity and 70 - 80% debt (some senior citizen investors may prefer such an asset allocation), then you can invest in aggressive monthly income plans (MIP), another type of hybrid fund, which usually has a similar asset allocation profile. If you want a more conservative asset allocation, you can invest in conservative monthly income plans, which have a lower allocation to equities.

If your asset allocation profile is somewhere in between of the different ranges discussed you can pair two or more hybrid fund with different asset allocation profiles in the necessary proportions to get to your target asset allocation. For example, if your desired asset allocation is 50% equity and 50% debt (many investors in the later stages of their careers may desire such an allocation), you can invest 60% of your money in a balanced fund which has 70% equity allocation and 40% of your money in an MIP which has 20% equity allocation; the combined asset allocation will be 50% debt and 50% equity. The percentages invested in different fund categories should be fairly simple to calculate; you can either use trial and error or just basic algebra to calculate the percentages.

How to know asset allocation of hybrid funds

Scheme names can give you clues about asset allocation of hybrid funds. For example, “balanced funds” usually have 65 – 75% equity allocation and 25 – 35% debt allocation. “MIP or Monthly Income Plans” usually have 5 – 30% equity allocation and balance debt allocation; aggressive MIPs have higher equity allocation, while conservative MIPs have lower equity allocation. While scheme name can give some clues regarding asset allocation, in our opinion, you should always check the current actual asset allocation of the fund, by looking up the scheme on mutual fund research websites like Valueresearchonline.com, Morningstar.in, Advisorkhoj.com, etc. You can also read the monthly funds factsheets to know the current asset allocation of hybrid fund schemes. You should know that, hybrid funds rebalance their asset allocation from time to time (more on that later). You should, therefore, also read the scheme information document to know the asset allocation ranges of a hybrid fund.

You may like to read a related topic here Optimize your asset allocation with balanced fund

Benefits of hybrid funds

• Volatility is an intrinsic characteristic of equity as an asset class. There is a saying that the stock market is not for the faint hearted. No investor, big or small, would like to entertain the prospect of losing money. Different investors have different attitudes towards volatility. Some investors have a high appetite for risk and are perturbed by volatility, but volatility can indeed be quite stressful for many retail investors. Many investors exit equities after losing 20 – 30% (maybe even more) of their money in bear markets; they run out of patience for the market to recover. Many investors do not want to pin their fortunes on vagaries of the stock market and shun equities altogether, preferring to sit on cash or low yielding term deposits, earning little or no real post tax returns. These investors have to contend themselves with sub-optimal returns which, most of the times, fail to beat inflation on a post tax basis. Hybrid funds are good investment options for such investors. Hybrid funds give investors the exposure to equity but the debt component cushions the fall in investment value, to a large extent, during market downturns and gives investor’s portfolio stability in different market conditions. During bull markets, these funds give good returns and over a sufficiently long investment horizon can generate capital appreciation for investors.


• For first time investors, stock markets can be bumpy ride. Even if they are investing in a bull market, a sharp correction can make first time investors very jittery. The recent correction in the market, from a Nifty level of 10,100 to 9,700 is a good example. We are still very much in a bull market, but the correction made quite a few investors I know, especially first time investors, quite nervous. At a time when interest rates are on their way downwards, the relatively low volatility of hybrid funds can put the money of first time investors at work more effectively, without causing any stress.


• Psychological considerations related with equity volatility aside, low volatility is often a necessity for investors who want regular income from their investments. Stability of returns from investments is a critical need for some investors, especially investors like senior citizens, who have no other source of income, other than investment income. Stock market volatility can cause disruption in income for such investors and therefore, these investors usually relied on traditional fixed income products like bank fixed deposits and small savings schemes. But declining interest rates and the taxability of interest income from the traditional fixed income products, have these investors are now concerned about how to meet their income needs. Hybrid funds are less volatile than equity funds and at the same time have the potential to give higher returns than fixed income products. These funds, therefore, can provide effective solutions for investors looking for income from their investments.


• One of the biggest advantages of hybrid fund is automatic asset rebalancing. Why is asset rebalancing required? Different asset categories have different rates of returns, causing your asset allocation to deviate from the optimal asset allocation over a period of time. For example, let us assume your optimal asset allocation is 50% equity and 50% debt. Further let us assume that for the next three years, annualized rate of equity fund return is 20% and annualized rate of debt fund return is 7%. What will be asset allocation of your portfolio after 3 years? It will be 59% equity and 41% debt, a deviation of +/- 9% from your desired asset allocation; in other words, you will be carrying more risk than you are supposed to, unless you rebalance your portfolio. In hybrid funds, the fund manager does the rebalancing for you from time to time, to bring it within the target asset allocation ranges (as specified in the investment mandate of the fund); you will find the target asset allocation ranges of hybrid funds in the scheme information document. Asset rebalancing gives your portfolio stability and also gets you superior risk adjusted returns.

Conclusion

In this post, we have discussed the basic characteristics and benefits of investing in hybrid funds. We have seen that, hybrid funds provide investment solutions for investors with moderate or low risk appetites, who want stable returns and limited downside risks. These funds are also suitable for investors who want regular income along with capital appreciation. As mentioned earlier in our post, there are different types of hybrid funds, which are suitable for specific risk appetites and investment needs. In the next few posts, we will discuss different types of hybrid funds in more details.