What are Hybrid Funds & why they are Relevant?

Equity funds invest in equity stocks and generate higher returns, but with a higher level of risk. Debt funds on the other hand invest in debt securities and generate moderate returns, but with a lower level of risk. 

Hybrid funds are funds that invest in a combination of equity stocks and debt securities, to provide investors with a good mix of risk and return based on the investors objectives.

3 Main Categories of Hybrid Funds

Conservative Hybrid

Invest primarily in Debt Securities, with an equity allocation of 10-25%. 

Suitable for conservative investors seeking to earn slightly higher returns than debt funds, but with little incremental risk

Taxed as debt fund. 

Equity Savings

Invest approximately 33% in debt, 33% in arbitrage and 33% in equity. 

Provide modest participation to equities, while helping protecting capital loss due to a 66% exposure to debt/arbitrage. 

Taxed as equity fund. 

Aggressive Hybrid

Invest 65% in equity stocks, with a 35% allocation to debt. 

Provide a lower-risk way to invest in equities, with the debt exposure helping reduce return volatility & risk of capital loss. 

Taxed as equity fund. 

Dynamic Asset Allocation

The Fund Manager can change his allocation between debt and equity based on the view of the markets. 

If the fund manager get’s the market view right (may not always be the case), this allows a higher participation in equities in bull markets, while reducing risks in bear markets. 

Typically taxed as equity fund (since FM’s tend to use arbitrage as a proxy to debt, to maintain 65% allocation in equity)

The Pros & Cons of Hybrid Funds

Any investor has the ability to create a portfolio with a similar risk-return portfolio to a hybrid fund, simply by investing in a combination of pure equity and debt funds in the same proportion. 

While the ultimate portfolio returns of the 2 methods are similar, hybrid funds offer a few advantages that make them a very good alternative to creating the portfolio allocation yourself. 

Lower Volatility

As an example, an investor in a conservative hybrid fund (20% equity) will have 1 scheme with low volatility. 

If he had the same asset allocation, with 80% in a debt fund and 20% in an equity fund, he would have 2 schemes (one with low volatility and one with high volatility). The equity fund’s volatility can impact investor sentiment & discipline, even if it is only a small part of overall allocation. 

Automatic Re-balancing

In a hybrid mutual, the fund manager will ensure that the asset allocation between debt and equity remains within a particular band.

However, in a portfolio constructed by the client, the exposure to equity will change based on market movements. This can lead to an investor having to re-balance the portfolio himself, often with costly load and tax implications. ​

Tax Advantages

Aggressive Hybrid Funds & Equity Savings Funds are both taxed as equity funds. This leads to the preferential equity taxation rates being applicable on the debt portion of the investments as well. 

On the other hand, if you invest in a combination of debt & equity funds, you lose the benefit of superior equity taxation on your debt investments. 

Goal-driven Asset Allocation

For many investors, the asset allocation may be driven by specific goals, with equity funds used for long-term goals and debt funds used for short-term goals. 

Short-term fund requirements can be met by redemption’s from debt funds, while keeping the longer-term equity investments intact. This is superior to meeting short-term fund requirements by selling units of a hybrid fund (that can lead to selling equity in unfavourable market conditions). 

Are Hybrid Funds suitable for you?

The benefits of lower volatility, automatic re-balancing and potential tax advantages make hybrid funds a very relevant fund category to consider. However, the relevance of this category is very dependent on your specific financial plan, risk-profile and liquidity requirements. 

If you would like to have a more detailed assessment of the suitability of hybrid funds to your unique requirements, you can set up a free-consultation below.