Hybrid Funds for Wealth Creation

Hybrid Funds are a lethal combination of equity and Debt Funds. However, it is usually difficult for a first-time investor to select the best fund among the many accessible possibilities. Henil Shah sheds some light on the hybrid fund category in this story and advises first-time investors in picking the correct hybrid fund 

Investing is one of the strategies that may help you reach your financial objectives in life. Many people, however, continue to rely on conventional saving methods such as bank fixed deposits (FDs), traditional life insurance plans and government schemes. People frequently use the terms ‘savings’ and ‘investment’ interchangeably. But they must recognise that there are significant differences between the two. Savings refers to the portion of your income that you set away, whereas investment refers to the portion of your savings that you actually put to work.

Having said that, things have changed in recent years, and with reduced returns given by various saving choices, investors are now shifting their investments to mutual funds. As first-time mutual fund investors, they are confronted with a profusion of alternatives, which frequently leaves them perplexed. In such cases, a hybrid fund is an excellent alternative for first-time mutual fund investors. You may now have a slew of questions about hybrid funds. In this article, we will go over all there is to know about hybrid funds, from what they are to the many types of hybrid funds and how to choose the best hybrid fund.

If we closely track the assets under management (AUM) trajectory of hybrid funds, we can find that it has increased from ₹3,41,445 crore to ₹4,79,918 crore in the last three fiscal years, representing a compounded annual growth rate (CAGR) of 12 per cent.However, the picture changes if we look at its AUM as a percentage of the overall AUM of open-ended schemes.As seen in the graph above, the contribution of hybrid funds’ AUM to total AUM decreased sharply from June 2019 to December 2020. However, it has now begun to climb and is currently approaching the pre-pandemic levels. Further, examining the trend of specific types of hybrid funds would assist us in determining which is the most popular.

The graph above vividly shows that aggressive hybrid funds were originally contributing the most to hybrid fund AUM. However, the pattern has shifted over time, and today balanced advantage funds or dynamic asset allocation funds contribute the most. As of March 2022, the balanced advantage fund accounts for 37 per cent of hybrid fund AUM, followed by aggressive hybrid funds and arbitrage funds, which account for 31 per cent and 20 per cent, respectively. In the midst of the complexity of the provided statistics and graphs, you may be asking what hybrid funds are and what are the various types of hybrid funds. In the following paragraphs, we will also discuss who should consider investing in them, which hybrid fund is appropriate for first-time investors, and what to consider before investing in them.

Defining Hybrid Funds

There are three categories of investments: equities (high risk – high return), debt or fixed income (low risk – low return) and hybrid (mix of equity and debt). A hybrid fund is simply one of the major types of mutual funds in which the funds invest in two or more asset classes. Although the majority of the funds’ asset allocation consists of a mix of stocks and bonds, only a handful of them have a broader asset allocation that includes gold, commodities and real estate investment trusts (REIT). Furthermore, even funds that seek to profit from arbitrage possibilities are categorised as hybrid funds. The primary concepts behind hybrid funds are asset allocation, correlation and diversification. Asset allocation is the process of spreading investments among multiple asset types.

Correlation, on the other hand, refers to how the returns of one asset fluctuate in relation to the returns of other assets. Finally, diversification is nothing more than spreading investments across many assets in a portfolio. Because the risk and return profiles of investments in identical asset classes are similar, there is frequently a positive correlation in returns. However, there is little to no correlation in returns when investing across asset classes. As a result, having a varied portfolio of assets with minimal correlation decreases portfolio risk. The hybrid fund manager adjusts the allocation to each asset class based on the fund’s investment goal and the general market environment.

Types of Hybrid Funds

According to the Securities and Exchange Board of India’s (SEBI) circular on mutual fund rationalisation, there are seven categories of hybrid funds in total.

✓ Conservative Hybrid Funds - Conservative hybrid funds invest around 75 per cent to 90 per cent of their entire assets in debt securities and associated products, with the remaining 10 per cent to 25 per cent committed to equity and related instruments. The primary goal of this fund is to earn income, thus it invests primarily in debt securities, although the equity portion of the portfolio contributes to the total return. Due to the lower returns on bank fixed deposits (FD), this fund may be a useful option for people searching for an alternative to FDs. By introducing some risk, this fund outperforms bank FDs in terms of returns.

✓ Aggressive Hybrid Funds -Aggressive hybrid funds invest a minimum of 65 per cent and a maximum of 80 per cent of their assets in equity and associated securities, with the remaining 20 per cent to 35 per cent committed to debt and similar products. When compared to equity mutual funds, the risk is on the lower end, while the possibility of better returns is higher when compared to other hybrid funds. Even in terms of taxation, these funds tend to gain because their taxation is similar to that of equity funds.

✓ Balanced Hybrid Funds - Balanced hybrid funds are permitted by SEBI guidelines to invest a minimum of 40 per cent and a maximum of 60 per cent in equities and associated instruments as well as debt securities. This fund’s primary goal is to achieve long-term capital appreciation by investing in equities while balancing risk through investment in debt. However, unlike other hybrid funds, this fund is not permitted to engage in arbitrage.

✓ Balanced Advantage Funds - Dynamic asset allocation funds, also known as balanced advantage funds, have asset allocations that can range from 100 per cent stock to 100 per cent debt. As a result, we may describe these funds as really dynamic in character. The asset allocation of a fund is often determined based on the investing philosophy and asset allocation models of the individual mutual funds. In terms of taxation, the majority of them are deemed equity funds for taxation and are taxed accordingly

✓ Multi Asset Allocation Funds - According to the SEBI requirement, a multi-asset allocation fund must invest in at least three asset classes, with a minimum of 10 per cent allocated to each asset class. These funds, in addition to equities and debt, include exposure to third asset classes such as gold, commodities, and real estate through REITs. This fund is designed for investors who want to diversify their holdings. The asset allocation in these funds is determined by the fund manager’s perspective.

✓ Arbitrage Funds - Arbitrage is a method in which you buy in the spot or cash market while selling in the futures market. Because of the price difference between the spot and futures markets, this is likely to create profits. This is accomplished through the use of derivatives, which are categorised as equity securities. Because there is no directional call in this activity, the volatility of returns is lower, and it tends to produce debt fund-like returns. Arbitrage funds typically invest 65 per cent to 100 per cent of their assets in stocks (through derivatives) and 0 per cent to 35 per cent in debt instruments. In the absence of arbitrage opportunities, however, these funds rely heavily on debt securities. This fund is better suited to people with a one-year investment horizon or shorter and who are in the highest tax bracket.

✓ Equity Savings Funds - The equity savings fund invests in stocks, derivatives and debt securities. These are the funds that invest in the aforementioned securities in an attempt to balance risk and return. Because these funds are exposed to derivatives, their directional exposure to equities is decreased, allowing them to manage volatility and provide steady returns. In terms of asset allocation, these schemes allocate around 65 per cent to 100 per cent of their assets to stocks including derivatives and 0 per cent to 35 per cent of their assets to debt securities.

Target Investors for Hybrid Funds

On account of the characteristics of these funds that differ greatly from those of other types of funds, it is necessary to comprehend their applicability. Hybrid funds are considered riskier than debt funds but less risky than equity funds. However, when it comes to long-term returns, they give better returns than debt funds but lower returns than equity funds. In terms of risk-return profile, these funds fall between equity and debt funds. As a result, these funds are appropriate for investors with a conservative to moderately conservative risk profile. This is due to the fact that those with a higher risk tolerance would be disappointed by the returns delivered by these products. Even individuals looking for a little amount of equity exposure might consider investing in them. Furthermore, if you are new to mutual funds and are unsure about investing in equities, this is the perfect place to begin.

Choosing the Best Hybrid Fund

When we refer to first-time investors, we mean those who are new to the equity markets and are apprehensive to investing in equities. As a result, for such investors, we recommend starting with either an aggressive hybrid fund or a balanced advantage fund. This will not only help them get a feel for investing in equities but will also protect them if things go wrong. To demonstrate this point, we compared the average returns of aggressive hybrid funds and balanced advantage funds in March 2020 to equity funds, excluding sectoral and thematic funds.

Pointers for Investing in Hybrid Funds Here are some guidelines that you need to keep in mind 

Risk
Although hybrid funds are safer than equities, it is not prudent to think that they are completely risk-free. The allocation to equities accounts for the majority of the risk in hybrid funds. It’s also a fallacy to think of debt investing as safe. This is so even if the debt portion of the portfolio is invested in government securities, which are free of credit risk but still subject to interest rate risk. Before investing in hybrid funds, compare risk measures such as standard deviation, Sharpe ratio, Sortino Ratio, beta, and so on.

Expense Ratio
The expense ratio is the cost of investing in mutual funds. It is accounted for in the fund’s net asset value (NAV). The smaller the expense ratio, the better it is. However, focusing just on the expense ratio is insufficient. If the fund is well-managed and provides more alpha, then the expense ratio may be overlooked.

Returns
Returns are one such measure that can assist you to comprehend the fund manager’s potential to build wealth for you. As a result, it is critical to examine fund returns. However, always look at the fund’s rolling returns since they provide a far better picture than trailing or absolute returns.

Investment Horizon
This is one of the most critical elements to learn before investing in hybrid funds. Knowing your investment horizon can assist you in selecting the best hybrid fund. If you have a one-year investment horizon and are in the highest tax bracket, an arbitrage fund is ideal for you. If you have a three-year investment horizon, a conservative hybrid fund is a suitable option. If your investment horizon is longer,

As seen in the graph below, when the markets plummeted in March 2020 owing to the spread of the pandemic, equity funds fell roughly 24 per cent, while aggressive hybrid funds lost 14.52 per cent and 13.33 per cent, respectively. As a result, it is clear that these hybrid funds fall less than equity funds amid market volatility. As a result, aggressive hybrid funds or balanced advantage funds make more sense for first-time investors.

Conclusion
Hybrid funds are funds that have the features of both equity and debt funds with a risk-return profile that is conveniently located between the two. Although these funds are well-suited for investors with conservative to moderately conservative risk tolerance, they are also an excellent alternative for first-time investors. As a first-time investor, you should first determine your risk tolerance. Most likely, it will fall somewhere between conservative and moderate. You may choose the best hybrid funds based on this and your investment horizon. If you are new to equities and are apprehensive about investing in them, aggressive hybrid funds and balanced advantage funds make sense. However, as a first-time investor, keep your expectations reasonable and remember that hybrid funds are not risk-free.