Have you heard of Hybrid Cars? Hybrid Cars are new age vehicles that run on both fuel and battery. The electric engine runs the car at lower speeds and the petrol engine powers it at higher speeds.
Unlike an all-electric model, hybrid vehicles offer a more standard driving range, better power and most don’t require charging. Compared to an all-petrol model, hybrid cars are fuel-efficient and environment friendly.
Mutual Funds adopt a similar concept. Hybrid Funds invest in both, equity and debt in a predetermined allocation. Thus, investors get the power or wealth-creation potential of equity and the stability of debt, in a single fund.
When the allocation towards equity is over 65%, such funds are referred to as Equity-oriented Hybrid Funds. Similarly, in Debt-oriented Hybrid Funds the allocation is tilted towards debt.
In this blog, we focus on equity-oriented hybrid funds. The simplest example of equity-oriented hybrid funds are Balanced Funds.
Until a few months ago, Balanced Funds were synonymous with equity-oriented Hybrid Funds that invested over 65% of their assets in equity. Clearly, Balanced Funds were a misnomer, as one would expect a 50:50 allocation to equity and debt. Soon SEBI through its circular on the Categorisation and Rationalisation of Mutual Fund Schemes replaced the so-called Balanced Fund with Aggressive Hybrid Funds.
So based on SEBI’s categorisation, there are basically three types of equity-oriented hybrid funds.
1. Aggressive Hybrid Funds – As per the circular, Aggressive Hybrid Funds will invest 65% to 80% of total assets in equities and 20% to 35% in debt instruments. Under Aggressive Hybrid Funds, a maximum debt allocation of 35% is specified, however, Aggressive Hybrid Funds have the flexibility to include an arbitrage exposure to reduce the risk of the portfolio.
2. Balanced Advantage Funds – SEBI created another category known as Balanced Advantage Funds. Under this category, the exposure to equity and debt can be managed dynamically. In almost all cases, Balanced Advantage Funds have kept an exposure of over 65% to equity. Thus, though the definitions as different, the first two categories are synonymous. Balanced Advantage Funds, however, gain from the added flexibility.
3. Equity Savings Funds – Equity Savings Funds are another category of equity-oriented hybrid funds. As per SEBI’s circular, such schemes will invest minimum 65% in equity & equity related instruments and a minimum 10% in debt instruments. The schemes minimum hedged & unhedged is to be stated in the SID, while its asset allocation under defensive considerations may also be stated in the Offer Document. Usually, such funds invest 20-25% in unhedged equity.
Benefits of Equity-oriented Hybrid Funds
The diversification of assets across equity and debt and within the respective asset classes lowers the risk a hybrid fund exposes you to, as compared to a pure equity fund. The exposure to debt securities provides stability and the returns are enhanced in a falling interest rate environment.
Aggressive Hybrid Funds have proved to be less volatile than Equity Diversified Funds. At times, such hybrid funds have even outpaced their equity-diversified peers.
Dynamic Management and Auto Rebalancing
When you invest in hybrid funds, you stand to gain with a tactical allocation to equity and debt. In a bull market, where the returns from equity run ahead of debt, the equity portfolio of an Aggressive Hybrid Fund may command a slightly higher weightage than 65%-70%. Thus, to maintain the required allocation, the fund manager may book profits in the equity segment and shift the proceeds to debt.
Conversely, if the stock market falls, the allocation to equity may drop below the desired level. Hence, to raise the allocation to equity, the fund manager may shift the assets from debt to equity. Deploying this strategy, the fund manager tactically allocates the assets, which can deliver reasonable gains over the long term.
Convenience and Tax Efficiency
A thought may cross your mind, that if you invest in a combination of the best equity funds and best debt funds, by maintaining the same asset allocation as a hybrid fund, you can do better in terms of performance. However, this means you need to put in extra efforts to pick two different schemes.
Not only this, you require to monitor the asset allocation on a regular basis. If you need to buy and sell the mutual funds to maintain the right allocation, you cannot ignore the tax implications. The capital gains tax norms are different for equity and debt schemes. Doing this becomes a gruelling task. By investing in an equity-oriented hybrid scheme, the long-term capital gains are tax-free upto Rs1 Lakh. Gains over Rs 1 lakh are taxable at 10%.
Through hybrid funds, you get the best of both worlds—equity and debt. Such funds have the ability to generate inflation beating returns at a lower risk. Such funds can shift across the two asset classes depending on the opportunities presented by the market.
Thus, you simply cannot ignore the benefits of a hybrid fund. If you would like to know more about the top performing Aggressive Hybrid Funds or Balanced Advantage Funds, write to us at WMS@plindia.com. You can check with us on our latest recommendations or send us your portfolios for a free -no obligation review!