What are Hybrid Mutual Funds?

Hybrid mutual funds are types of mutual funds that invest in more than one asset class. Most often, they are a combination of Equity and Debt assets, and sometimes they also include Gold or even Real estate.

The key philosophies behind hybrid funds are – asset allocation, correlation, and 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 basis the investment objective of the fund and the market condition.

1. Types of Hybrid Funds

• Multi Asset Allocation Fund: These schemes need to have investments in at least three 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 basis 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 75 to 90 percent is to be invested in debt instruments. The aim of these funds 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 in 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, and 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. This 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.

2. 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, and 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 3-5 years. The longer the time horizon, the better the chances of getting stable, higher returns.
• Cost: Like any other mutual funds, hybrid funds also charge a fee known as the expense ratio. The lower the expense ratio, the better for the investor. Although a high expense ratio impacts the fund returns, it is not necessary that the high expense ratio will always give low 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.

3. Hybrid Fund Advantages

• Access multiple asset classes with a single fund: One of the clear advantages of hybrid mutual funds is that instead of investing in different funds to meet the need for different asset classes, an investor can access multiple asset classes in a single product.
• Active Risk Management: Hybrid mutual fund provides active risk management through portfolio diversification and asset allocation. They manage risk by combining non-correlated asset classes like equity and debt.
• Diversification: They diversify the portfolio not only across asset classes but also across sub-classes within the asset class. Like within the overall Equity allocation, they invest in large cap, mid cap, or small cap stocks, value, or growth stocks.
• Caters to various risk profiles: These funds can offer varying levels of risk tolerance ranging from conservative to moderate and aggressive. There are equity-oriented schemes for the risk-taker and debt-oriented schemes for the risk-averse and the Dynamic Asset Allocation Fund for those who do not want to stick to a fixed Asset allocation but want to move basis market views without taking the calls themselves. Arbitrage for investors who are looking for stable returns in a volatile environment.
• Buying low and selling high: The fund managers rebalance the portfolio to adjust the asset allocation within the permissible limit leading to selling a particular asset class when high and buying when low.
• Automatic Rebalancing: The fund manager rebalances the portfolio as and when required, and the investor does not have to do it at his end. They save the time and effort required to track the markets and manage the asset allocation.

4. How to Find the Best Hybrid Fund

Hybrid funds are evaluated on the basis of consistency in return, fund management team, vintage, corpus, risk, return, and expense ratio.

Best hybrid funds are those which consistently lie in the top 25% of their peer group over a period of time. However, it is important to see the risk that they have taken to achieve those returns.

It is also important to look at the launch date to understand the period of existence and performance across the period.

Best hybrid funds also have a reasonable corpus size. Not too small that there is not enough attention given and not too large that it becomes difficult to manage.

An experienced fund management team with a good research base and market knowledge also plays a significant point to make a choice.

5. Summary

• Hybrid mutual funds are types of mutual funds that invest in more than one asset class typically a combination of Equity and Debt assets, and sometimes they also include Gold.
• The key philosophies behind hybrid funds are asset allocation and diversification.
• They aim to generate capital appreciation through equity allocation and to reduce the volatility through the debt component of the portfolio.
• Hybrid funds offer varying levels of risk tolerance ranging from conservative to moderate and aggressive.
• They serve as a good entry point for new investors in the equity market, also can be used for saving for any specific medium-term goal.

6. Frequently Asked Questions (FAQs)