Unlocking Hybrid Mutual Funds

Hybrid mutual funds are a type of mutual fund that invests in both equity and debt securities. This mix of assets makes Hybrid Funds a relatively less risky investment option than pure equity funds, while offering the potential for higher returns than pure Debt Funds. The article highlights how hybrid funds can add value to your portfolio[EasyDNNnews:PaidContentStart]

Currently, almost all the equity indices, including sectoral and thematic ones, are hovering around their all-time highs. This is in stark contrast to just a few quarters ago when many of these indices were trading at their yearly lows. Such rapid gains in such a short period may have disrupted the comfortable asset allocation of many portfolios. It’s possible that the weightage of your equity holdings has exceeded your intended threshold. In such a situation, it’s prudent to reconsider your asset allocation strategy. 

Taking a strategic approach to asset allocation is crucial for investors, although it’s easier said than done. It involves calculating the amount to be reallocated, deciding where to reinvest, and considering any exit loads and tax implications. In such a scenario, hybrid mutual funds present an attractive solution. These funds offer diversified portfolios that include a balanced mix of equity and debt instruments and in some cases commodity, catering to a range of risk appetites and financial goals.

What are Hybrid Funds?

Hybrid mutual funds are a type of mutual fund that invests in both equity and debt securities. This mix of assets makes hybrid funds a relatively less risky investment option than pure equity funds, while offering the potential for higher returns than pure debt funds. The chart below clearly shows the average returns of different categories of funds in different periods of time. It also highlights the fact that whatever period you choose, the returns of hybrid funds on an average lie between equity and debt. For example, in the last one year, equitydedicated funds from different sub-categories on an average gave return of 23.29 per cent while debt funds with its subcategories generated return of 6.97 per cent in the same period and hybrid funds generated return of 12.25 per cent in the same period. 

As of the conclusion of August 2023, hybrid funds boasted asset under management (AUM) of ₹5.61 lakh crore, marking a notable 16.5 per cent increase over the past year. Within the mutual fund industry, the hybrid fund category represents approximately 12.2 per cent of the total AUM as of August 2023. There hasn’t been any significant alteration in their overall AUM percentage share over the past year. This stability may be attributed to the substantial mark-to-market gains experienced by equity funds owing to the robust performance of the equity market in the past six months, causing their share of the total mutual fund AUM to increase from 38 per cent to 40 per cent during the same period.

The growth in AUM for hybrid funds can also partially be ascribed to gains in the mark-to-market valuation of their equity portfolios. Nonetheless, there were total inflows amounting to ₹26,374 crore in the past year. Comparing this figure with the total AUM increase of ₹79,500 crore, it becomes evident that inflows accounted for 33 per cent of the overall AUM growth in this category, while the remainder was attributable to mark-to-market gains.

Over the past year, the inflows into hybrid funds have exhibited a bout of volatility. After experiencing outflows in September 2022, October 2022 and November 2022, there was a substantial outflow exceeding ₹12,000 crore in March 2023. One of the primary reasons behind this outflow was the desire to capitalise on indexation benefits on the part of investors. There had been some modifications regarding the availability of indexation benefits for debt investors after March 2023. 

Consequently, many investors chose to exit from hybrid funds and redirected their investments towards corporate bond funds,banking and PSU funds, dynamic bond funds, long-duration funds and gilt funds. This shift resulted in inflows totalling approximately ₹39,000 crore toward debt funds as investors sought to leverage the advantages of indexation. Nevertheless, it has stabilised since the start of FY24 and hybrid funds have witnessed cumulative inflows of ₹26,374 crore between April 2023 and August 2023. The graph below shows the inflows to hybrid funds in the last one year.

Hybrid mutual funds in India have gained significant prominence. These dynamic investment vehicles offer investors a unique blend of asset classes, combining the stability of debt with the growth potential of equity. The introduction of the SEBI categorisation and rationalisation of mutual funds in October 2017 brought further clarity and structure to the hybrid fund space.
 

Understanding SEBI’s Rationalisation

Market regulator Securities and Exchange Board of India (SEBI)’s move to categorise and rationalise mutual funds was aimed at streamlining the industry and making it more investor-friendly. Under this framework, hybrid mutual funds are classified into several categories based on their asset allocation and investment objectives.

Different Types of Hybrid Funds and Distinctions

SEBI has classified hybrid mutual funds into six sub-categories. The main difference between the different types of hybrid funds is their asset allocation. Aggressive hybrid funds are the most equity-oriented hybrid funds, while conservative hybrid funds are the most debt-oriented hybrid funds. Balanced hybrid funds and equity savings funds are somewhere in between. Based on asset allocation, these funds generate corresponding returns. So, for example, aggressive hybrid funds that invest more in equity generate better returns than other sub-categories of hybrid funds. Similarly, arbitrage funds that generate riskless profit do have one of the lowest returns among the hybrid sub-categories.

Conservative Hybrid Funds - These funds primarily invest in debt instruments and allocate a smaller portion to equities, typically ranging from 10 per cent to 25 per cent. Conservative hybrid funds are well-suited for risk-averse investors seeking stability and modest growth.

Balanced Hybrid Funds - Also known as balanced funds, these maintain a balanced allocation between equity and debt, with a 40-60 per cent split. Their allocation towards equity offers the potential for capital appreciation while debt exposure to an extent cushions against market volatility in equity investment.

Aggressive Hybrid Funds - Formerly known as balanced funds, they have a higher equity component, generally around 65-80 per cent, making them suitable for investors with a moderate risk appetite seeking wealth creation.

Based on SEBI guidelines, mutual fund houses are permitted to offer either an aggressive hybrid fund or balanced fund.

Among hybrid funds, aggressive funds have generated the best returns.

Dynamic Asset Allocation or Balanced Advantage Funds - These are the most unique type of hybrid funds as they can dynamically adjust their asset allocation between equity and debt. This makes dynamic asset allocation funds a good option for investors who want to invest in a hybrid fund, but don’t want to worry about making asset allocation decisions themselves. These funds adjust their equity exposure dynamically based on market conditions, aiming to maximise returns while managing risk. Equity allocation can vary from as low as 30 per cent to as high as 80 per cent, depending on market conditions.

Arbitrage Funds - These funds leverage arbitrage opportunities between the cash and derivatives markets. They aim for relatively lower risk and tax-efficient returns by capitalising on the price differentials in two separate markets, as for example, the price difference between cash and future or between two exchanges.

Equity Savings Funds - These funds invest 65-80 per cent of their assets in equity and equity-related instruments and 20-35 per cent in debt instruments. These funds are designed to provide investors with tax benefits on their investments.

Multi-Asset Allocation Fund - These types of funds typically have a more diversified asset allocation than other types of hybrid funds. For example, a multi-asset hybrid fund may invest 30 per cent in equity, 30 per cent in debt and 20 per cent in gold. A typical hybrid fund, on the other hand, may invest 65 per cent in equity and 35 per cent in debt. Multi-asset hybrid funds are a good option for investors who are looking for a diversified investment that can provide both growth and income potential. They are also a good option for investors who are new to investing and do not want to take on too much risk.

Financial Planning with Hybrid Funds

Hybrid mutual funds are versatile tools for financial planning, catering to a wide spectrum of investment goals:

1. For investors seeking stability alongside growth potential, conservative hybrid funds are an attractive choice. These funds predominantly invest in debt instruments while allocating a smaller portion to equities. They are ideal for risk-averse individuals who wish to protect their capital while earning modest returns.
2. Balanced hybrid funds maintain a well-rounded allocation between equity and debt, typically with a 40-60 per cent split. This category is suitable for those looking to strike a balance between capital appreciation and risk mitigation. It can act as a buffer during market fluctuations.
3. For investors with a moderate risk appetite and a desire for wealth creation, aggressive hybrid funds are worth considering. These funds maintain a higher equity allocation, often ranging from 65 per cent to 80 per cent. They provide the potential for substantial returns while leveraging debt to manage risk.

Selecting the Right Hybrid Fund

Choosing the right hybrid mutual fund requires a careful assessment of your financial goals, risk tolerance and investment horizon. Here are some key factors to consider:

1. Asset Allocation - Evaluate the fund’s asset allocation strategy and ensure it aligns with your risk profile. So, if you are a conservative investor, look for a fund that invests more in fixed income. Even in equity, go for funds that have large exposure to Large-Cap stocks. Analysing the entire spectrum of hybrid funds that have exposure to equity, we find that some funds have exposure towards large-caps to the extent of 70 per cent while some have exposure of a mere 3 per cent. So, one can choose funds based on such allocation.
2. Expense Ratio -It is observed that lower expense ratios can go a long way in enhancing your investment returns. At the end of August 2023, the average expense ratio of hybrid funds comes at 1.83 per cent, while the maximum and minimum stands at 2.6 per cent and 0.63 per cent, respectively. Keeping everything equal, you should go for a fund that has lower expense ratio.
 3. Historical Performance - Though history may not repeat itself, analyse the fund’s historical returns, especially risk-adjusted returns, as that will give you some sense on how the funds can perform and the associated risks.
4. Exit Load and Tax Efficiency - These are the two costs associated while exiting a fund. Depending upon the mix of securities, you need to pay different tax amounts, which will also depend on your holding period. Understand the fund’s exit load and tax implications since that will help you to make informed decisions.
5. Investment Horizon - Choose a fund with a suitable investment horizon that matches your financial goals. In case there is mismatch between them, you might not get the optimal benefit of your investment.

Hybrid mutual funds have emerged as versatile tools for Indian investors, offering a balanced mix of stability and growth potential. SEBI’s categorization has brought clarity to this space, making it easier for investors to select funds that align with their financial objectives. By carefully assessing your needs and preferences, you can harness the potential of hybrid funds to achieve your financial goals. In conclusion, as the markets reach new highs, investors can navigate these uncertain times with a well-thought-out asset allocation strategy through hybrid mutual funds. Assessing your risk tolerance, investment horizon and financial objectives is crucial in determining the most suitable category within the hybrid fund space. Consulting a financial advisor can further tailor your investment strategy to your unique circumstances. 

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