All About Hybrid Category Of Mutual Funds

All About Hybrid Category Of Mutual Funds

Portfolio risk can be reduced by combining assets that have a low correlation

Viral BhattUpdated: Saturday, November 25, 2023, 09:51 PM IST
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The key philosophies behind hybrid funds are: (1) asset allocation, (2) correlation, and (3) diversification. Asset allocation is the process of deciding how to distribute wealth among various asset classes, and correlation is the co-movement of returns of the assets, and diversification is to have more than one asset in a portfolio.

Since the sources of risk and factors affecting returns are similar for the investment options within an asset class, they tend to exhibit a high level of correlation in returns, whereas investment options across asset classes show little correlation in returns.

Portfolio risk can be reduced by combining assets that have a low correlation. Hybrid mutual fund schemes diversify the investment within multiple asset classes to try and achieve maximum returns at minimum possible risk.

The allocation to each asset class is decided by the fund manager based on the investment objective of the fund and the market condition.

Types of hybrid funds

Multi asset allocation fund: These schemes need to have investments in at least 3 asset classes with a minimum of at least 10 percent in each of the asset classes. These funds give the investors the exposure to investing in more asset classes, and based on the view of the fund manager, the asset allocation is decided.

Aggressive hybrid funds: These schemes are mandated to invest a minimum of 65 percent and a maximum of 80 percent in the equity asset class and 20 to 35 percent in the debt asset class. They provide a possibility of high returns at reduced risk through the small allocation to debt. They benefit from the taxation applicable to equity-oriented schemes.

Dynamic asset allocation or balanced advantage fund: These schemes are truly dynamic and can shift between 100 percent debt to 100 percent equity asset class. The asset allocation is decided based on the recommendation of the financial model deployed by the fund. These funds are suitable for investors who want to automate their asset allocation.

Conservative hybrid funds: These schemes are required to invest 10 to 25 percent of their total assets in equity and equity-related instruments. The remaining 90 to 75 percent is to be invested in debt instruments. The aim is to generate income from the debt component of the portfolio and use the small equity component to provide a kicker to the overall return. It is a good option for people looking for debt plus returns and are willing to take a little extra risk.

Equity savings fund: These funds try to balance risk and returns by investing equity, derivatives and debt. Derivatives reduce directional equity exposure, thereby reducing the volatility and generating a stable return. The equity asset provides growth and debt, while derivative provides the regular stable returns. These schemes invest 65 to 100 percent in equity assets and 0 to 35 percent in debt asset classes.

Arbitrage fund: Arbitrage strategy is buying in the cash market and the simultaneous selling in the futures market to generate returns through the price differential between both markets. It is done through derivative instruments, which are categorized as equity-oriented instruments. Since there is a simultaneous buy and sell, there is no directional call on the stock and hence does not carry the volatility of the equity asset class and generates a stable debt-like return. These schemes invest 65 to 100 percent in equity assets and 0 to 35 percent in debt asset classes. This fund is suitable for low-risk investors who want to generate debt like returns with equity taxation in a high volatility period.

Things to consider before investing in hybrid funds

Like any other investment, it is important to understand the various parameters such as investment risk, expected returns, investment horizon, and costs involved before making the investment decision.

Returns: Hybrid funds don’t offer guaranteed returns. Their returns are affected by the performance of the underlying investments. The equity market performance will affect the returns to the tune of equity exposure of the fund. The returns of an aggressive oriented hybrid fund will be more correlated with the equity markets as compared to the balanced and conservative-oriented hybrid fund. In a rising market, its performance lags the funds with 100% equity allocation. In a falling market, it will outperform pure equity funds. Dynamic asset allocation fund can move between equity and debt without any caps. And they increase/decrease their allocation to equities and debt depending upon the outcome of financial models based on which the fund is managed.

Risk: Investment in hybrid funds is not devoid of risk. The risk in a hybrid fund primarily depends upon the proportion of equity holding in the portfolio. The higher the equity component, the riskier the fund. The segment of the equity market in which the fund invests and the strategy used will define the risk of the equity component. In the case of debt-oriented funds, risk will be defined by whether the debt portion is managed for interest income or capital gains. A fund that gets its return mainly from interest income of debt securities may be less risky than a fund that relies on gains from price appreciation. Arbitrage funds are low-risk products as no directional call is taken.

Time horizon: Hybrid funds are suited for a medium-term time horizon say from 3 to 5 years. The longer the time horizon, the better the chances of getting stable, higher returns.

Investment strategy: It is important to note that the combination of assets selected, the proportions in each asset and the investment style are determined by the fund managers. Investors cannot influence how the various components may be chosen or combined.

(Viral Bhatt is the Founder of Money Mantra, a personal finance solutions firm)

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