Hybrid mutual funds are a subset of mutual funds that hold securities from multiple asset classes. They typically consist of a mix of equity and debt assets, though occasionally they may also contain gold or even real estate. The three main tenets of hybrid funds are diversification, correlation, and asset allocation. Asset allocation is the decision-making process that determines how to divide wealth across different asset classes; correlation is the co-movement of asset returns; and diversification is the inclusion of multiple assets in a portfolio.
Investment options within an asset class typically display a high level of return correlation, whereas investment options across asset classes tend to show low return correlation because the sources of risk and factors impacting returns are comparable.
By mixing assets that have minimal correlation, portfolio risk can be decreased. Hybrid mutual fund schemes distribute investments across a number of asset classes in an effort to maximise returns while minimising risk. The fund manager determines the allocation to each asset class based on the fund's investment objective and the state of the market.
Category of Hybrid Mutual Funds: -
1. Conservative Hybrid Fund
These funds have a debt investment range of 75% to 90% and an equity exposure range of 10% to 25%. The debt component of the portfolio may be invested in sovereign, state, public sector undertaking (PSU), and corporate securities across all maturities using an accrual or duration strategy, depending on the mandate of the fund. Some funds may additionally invest up to 10% of their assets in real estate investment trust (REIT) and infrastructure investment trust (InviT) units in addition to debt and equity.
Due to the possibility of allocating up to 25% of the portfolio to equities, these funds may offer marginally higher returns than debt funds. Nevertheless, the equity allocation may also mean that the fund will lose money if the market declines. Investors need to have an investment horizon of at least one year or longer in such funds because the fund's Net Asset Value (NAV) may fluctuate as a result of equity exposure. Since these products have a somewhat high risk, investors should ideally steer clear of putting funds intended for creating an emergency corpus in this category.
2. Balanced Hybrid
These funds maintain a 40 to 60 percent equity exposure. The debt portfolio might also fluctuate between 40% and 60%. Arbitrage is prohibited under Securities and Exchange Board of India regulations in this category. You can see that the equity exposure in the Balanced Hybrid category is on the higher side (minimum 40% and maximum 60%) as compared to the prior category (Conservative Hybrid, 10-25% equity allocation). As a result, Balanced Hybrid Funds have the potential to provide substantially higher alpha but also carry the risk of equity-related volatility. Investors in this group should have a time horizon of at least three years.
3. Aggressive Hybrid Fund
These funds invest more in equity, as their name would imply. They may invest up to 85% of their total investment, with a minimum of 65%. They may borrow anywhere from 20% to 35% of their total assets. These funds have the potential to create higher alpha than the Balanced Hybrid category due to their higher exposure to equities, but they may also be more sensitive to bigger drawdowns. When making an investment in this area, investors should have a time horizon of at least three years.
4. Dynamic Asset Allocation or Balanced Advantage Fund
These funds have the flexibility to adjust their exposure to debt and equities however the fund manager sees suitable. Using criteria like Price to Earnings Per Share (PE) and Price-to-Book (PB) level of the larger index like the Nifty 500 or S&P BSE 500, these funds modify their equity allocation based on market valuations. These funds change their allocation from equity to debt and vice versa when markets are overheated. While some funds are designed as Fund of Funds that invest in other funds or in house equity and debt schemes, others invest directly in equities. The best investment horizon for investors in this category is three years or longer.
5. Multi Asset Allocation
These funds have a minimum allocation of 10% in each of the three asset classes (equity, debt, and gold) and invest in all three. The fact that gold has a negative correlation with stocks is a benefit of including it in the portfolio. We can determine how two investments are moving in respect to one another using correlation. When two assets have a perfect negative correlation, or -1, their prices move in the opposite direction from one another. This is known as a positive correlation. Investors should be aware that even though these funds must maintain a minimum of 10% in each asset class, their allocation to equity may be high depending on market prices.For instance, some funds in this category currently allocate between 50% and 70% of their assets to equity.
6. Arbitrage Funds
For at least 65% of their portfolio, these funds take arbitrage positions in equities and associated instruments. The majority of the remaining corpus is held in cash and equivalents, as well as high-quality fixed-income securities. The goal of arbitrage funds is to profit from the price difference between the spot and futures markets. Investors having a time horizon of more than three to six months, especially during volatile times, can invest in this category. The typical exit load for these funds is between three and six months. When the market is constantly fluctuating, risk-averse people can put their excess cash in arbitrage funds in a secure manner. These funds are taxed more favourably than, say, liquid funds because they are classified as equity funds. Gains in Arbitrage Funds are taxed at 10% for holding periods of 1 to 3 years (only excess gains over Rs 1 lakh are taxed), as opposed to 30% for investors in the highest tax rate.
7. Equity Savings
These funds allocate at least 65% of their entire assets to equity investments, arbitrage, and at least 10% to debt investments. Since they fall within the category of equity funds, these funds are more tax efficient than Conservative Hybrid Funds. These funds seek to offer modest equity capital growth along with a consistent income from a debt and arbitrage portfolio. In these types of programmes, a year or longer should be the appropriate investment horizon.
Risks of Hybrid Funds: -
Although the amount of risk involved in hybrid funds can range from aggressive to moderate to conservative, a lot depends on how the various assets are distributed among the funds. Hybrid funds are thought to be the ideal choice for both beginning and experienced investors, and investors can select the best type of hybrid fund for them based on the level of risk they can tolerate.
Higher exposure to Equity: Some fund managers in hope of higher returns, increase exposure to equity and sometimes to volatile equity. The plan can fail as a result, losing its value.
Debt Holdings: The portfolio may lose value if the fund holds long-term bonds and interest rates rise.
Taxation on Hybrid Funds: -
1. Equity
Equity funds are taxed, including equity arbitrage and savings funds. You would be subject to equity funds taxation, which is 10% tax on gains over Rs 1 lakh, while short-term capital gains are taxed at 15% + surcharge, if you invest in a fund that invests at least 65% of its assets directly in stocks.
2. Debt
Conservative hybrid funds are subject to debt fund taxation since at least 75% of their assets are invested in debt instruments. You will be subject to debt fund taxation if you invest in a Dynamic Asset Allocation or Balanced Advantage Fund that is set up as a Fund of Fund.
If held for more than 36 months, long-term capital gains (LTCG) tax is 20% (plus surcharge, if applicable, and cess), with indexation.
The tax on short-term capital gains (STCG) If held for fewer than 36 months, the income tax slab rate