This article on hybrid funds was originally published as part of an article on debt fund categories in June 2020. We are now republishing this as a separate article for the benefit of our newer subscribers.
Hybrid funds, as you would know from their name, combine different asset classes. Most hybrid funds are a mix of equity and debt. Some categories will include commodities – gold or other commodities.
In hybrid fund categories, risks come through equity (extent of exposure). Debt serves to reduce this risk. Hybrid funds have the additional component of derivatives (stock & index futures and options) that help reduce equity risk, but count as equity allocation for tax purposes. But do remember that higher the derivative component in the equity portion, the more it will cap return potential.
The allocation between equity, debt, derivatives (if applicable) and commodities (if applicable) all vary between funds within each category. Therefore, it is important to know this allocation before investing in a fund. More on this aspect is explained in the sections below.
Here’s how you can use the categories:
Arbitrage funds
Arbitrage funds hedge their entire equity portfolio through derivatives and are therefore low risk. The key advantage arbitrage funds have is their taxation, since they are taxed as equity funds. Purely on returns alone, arbitrage funds have often been lower than even liquid funds. The tax impact on debt funds is the primary factor that pulls post-tax returns down, compared to liquid funds.
Suitability, how to choose & use
- Arbitrage funds are primarily useful if you are in the higher tax brackets (15% and above). They are suitable for holding periods of a few months to a 1-2 year timeframe. Other investors can skip the category, and invest simply in fixed deposits, liquid funds, or other very short maturity funds depending on time frame.
- Use arbitrage funds only as temporary avenues to hold short-term money. Don’t use them to run STPs or SWPs. They can be loss-making even on a 1-month basis (low chances, but not impossible) and they depend on available arbitrage opportunities which can dry up in difficult markets.
Equity savings funds
These funds usually have low net equity exposure (total equity minus the derivative exposure). That is, these funds use derivatives to hedge the equity exposure and reduce risk, while the unhedged equity will aid returns. For funds in the category, long-term average net equity exposure has been at about 40-45%. These funds tick the tax-efficiency box as they qualify as equity funds for tax purposes. Therefore, the equity plus the tax benefit serve to help these funds generate better-than-debt returns, while being low on risk – making them suitable even for short-term timeframes.
Suitability, how to choose & use
- This category is suitable for those with a 1.5-3 year timeframe, across risk appetites and tax brackets.
- In short-term portfolios, they can be mixed with pure debt funds to balance risk and return. For example, our readymade 1-3 year timeframe Prime Portfolio or the Capital Preservation portfolio use such a mix.
- When choosing funds, run a check on their net equity and their derivatives. This will tell you how aggressive that fund is. The higher the net equity, the more aggressive it is and the more volatile it can be.
- In most cases, you can avoid using equity savings funds for portfolios beyond 5 years. You can use balanced advantage/ dynamic asset allocation funds or multi asset allocation funds instead, as these categories have higher return potential.
Balanced advantage/ dynamic asset allocation
Dynamic asset allocation funds and balanced advantage funds are the same in terms of what they do; it’s just that SEBI mandates that a fund calls itself one or the other. These funds, like equity savings, use derivatives to hedge equity allocation and reduce risk. But balanced advantage funds have much higher open equity exposure compared to equity savings funds and are therefore more volatile and can see bigger losses during market corrections.
It’s also important to note that in the balanced advantage category, the derivative exposure varies extremely widely between funds – much more than it does with equity savings. Therefore, funds can be extremely conservative in their approach or extremely aggressive while still belonging to the same category. A conservative approach means that the fund tends to maintain higher derivatives (i.e., hedge more) or does not swing between very low to no hedging to very high hedging. An aggressive approach will see the fund either avoid hedging altogether or set at low levels or change it frequently.
Suitability, how to choose & use
- The role of the fund in your portfolio depends on its strategy. In general, balanced advantage funds suit investors across risk profiles. Like with equity savings, these funds can be used to improve portfolio returns without raising the risk too much and score on tax efficiency.
- You can use those with conservative approaches in 1-3 year portfolios. Avoid using the more aggressive funds in portfolios of less than 3 years.
- In long-term portfolios, they are a better alternative to equity savings funds, owing to their higher return potential. You can go for funds with both aggressive or conservative approaches here, based on your risk profile and the other funds/categories in your portfolio.
- Given the change in long-term debt taxation from April 1st, 2023 onwards, these funds are also useful to partly replace the debt component in long-term portfolios. However, do not replace debt entirely with these funds as they are not pure debt substitutes and debt works the best in containing portfolio downsides.
- You can refer to Prime Funds for recommendations – the Hybrid Equity – Low Risk houses equity savings and balanced advantage funds with conservative approaches and the Hybrid Equity – Moderate Risk contains the more aggressive funds.
- New investors who do not have a large enough investment to do a proper asset allocation (say SIP investments of less than Rs 5,000), can also use these funds.
Aggressive hybrid funds
These funds offer a lower-risk route to equity and need a timeframe of 3 years at least. These funds are plain-vanilla hybrid funds blending equity and debt with no active derivative strategies. These funds are lower on risk than pure equity funds, but score above the equity savings or balanced advantage categories in terms of both risk and return.
Suitability, how to choose & use
- Aggressive investors who want high equity allocation can opt for some allocation to these funds, instead of going for pure equity funds. Many aggressive hybrid funds invest across the marketcap curve, offering reasonable participation in equity markets.
- New investors with investment amounts not large enough to do proper asset allocation, can opt for this category (or balanced advantage funds) as well. Given that these funds are also simpler to understand than balanced advantage funds, new investors may find them better-suited to their needs.
- Otherwise, you can skip this category. Asset allocation can be achieved with pure debt and equity funds. For short-term timeframes, equity savings or balanced advantage funds would be better fits.
Multi-asset allocation funds
These funds are a new category, comparatively, having been introduced in SEBI’s 2018 recategorisation of mutual funds. These funds have not really seen a variety of equity market cycles, since many in the category are fairly new funds. Theoretically, these funds just need to hold a minimum of 10% in at least 3 asset classes and can swing between these based on opportunities in each asset class.
However, these funds had a new factor to deal with – the change in tax rules that removed indexation benefit in long-term capital gains for funds that hold less than 35% in domestic equity. That meant funds are now increasingly using derivatives in their portfolio to reduce equity exposure instead of increasing debt, when equity markets are unattractive just to maintain equity exposure at a minimum of 35%. Some funds are aiming to keep equity at 65% too, to qualify as equity funds for taxation purposes. Up until then, these funds typically increased debt exposure when debt turned more attractive than equity.
Suitability, how to choose & use
- All of the above means multi-asset allocation funds are best used like aggressive hybrid funds in a portfolio – as a means to add equity and improve return potential without going for the risk of a pure equity fund. Multi-asset allocation can be used simply as diversifiers in a portfolio. They cannot be used to influence your portfolio’s asset allocation.
- These funds are also suitable only in long-term portfolios as they are equity-heavy, and the strategy of shifting into and away from equity based on market cycles is one that plays out only in the long term.
- As with the other hybrid categories, always run a check on how aggressive the fund’s strategy is to make sure that it meets your requirements.
Need help identifying funds under these categories and to know what the equity-debt allocation, derivative allocation, and other details? The Prime MF Screener will let you easily and efficiently compare, evaluate and shortlist funds based on metrics that actually matter. You will therefore be able to draw up an actionable and meaningful shortlist.
Other categories
The following categories can be skipped. Please don’t ask us whether you need to sell them if you hold them 😊 What we mean is that you won’t miss much if you don’t own them. A quick note on why is as follows:
- Conservative hybrid funds: These funds have been poor performers with no consistency in returns. These funds can change debt strategies which introduces unpredictability. They may also have credit risk. Instead, use pure debt/equity mix or equity savings/balanced advantage funds. This apart, the new tax rules over taxation of long-term capital gains will see these funds be tax-inefficient, especially when categories such as equity savings or balanced advantage are able to be tax-efficient, keep risks contained, and deliver debt-plus returns.
- Pension funds/ retirement funds/ children’s gift funds: Generally, these can be skipped. These funds have long lock-ins and many have high exit loads which make it difficult to switch out in cases of underperformance. Barring a few, these funds also do not score on performance when compared to other hybrid funds (or pure equity/debt funds when the solution fund is predominantly equity or debt oriented). While tax savings is a draw in some, you can achieve the same with ELSS funds, and with the new tax regime, it may not even be necessary to do so. Asset allocation too can easily be achieved with equity and debt funds.
