Since the March 2020 crash, investors have flocked to the Hybrid Funds category in a bid to cushion the downturn during volatile times and at the same time participate in equity at a comparatively lower risk.
The asset size of the Hybrid category has ballooned by 90% from Rs 2.62 lakh crore in March 2020 to Rs 4.97 lakh crore as of February 2022. Reflecting this trend, the number of investor accounts in this category has grown from 95.72 lakh to 1.13 crore during the same period. Dynamic Asset Allocation or Balanced Advantage Funds and Balanced Hybrid Fund/Aggressive Hybrid Fund have particularly seen dramatic growth in assets during this period.
As the name suggests, Hybrid Funds combine a mix of assets like equity, debt, arbitrage, gold, silver to offer a relatively lower risk (depending on the quantum of equity exposure) way of participating in equity as compared to pure equity funds, where equity exposure goes up to 95%.
But the sheer number of funds (there are 137 Hybrid schemes as of February 2022) and the given the fact that there are seven subcategories can overwhelm investors. Not all funds are similar, and it is important to look under the hood to understand how they operate.
In this post, we shall try to examine how each of these subcategories are different.
1) Conservative Hybrid Fund
These funds can invest from 75% to 90% in debt while the equity exposure can range from 10% to 25%. Depending on the fund’s mandate, the debt portion of the portfolio could be invested in Sovereign, State Government, Public Sector Undertaking (PSU) and corporate securities across all maturities, with an accrual or duration strategy. Besides debt and equity, some funds may also invest in units of Real Estate Investment Trusts (REITs) and Infrastructure Investment Trust (InviTs) up to 10%.
These funds could provide slightly higher returns than debt funds as up to 25% of the portfolio can be allocated to equity. That said, the equity allocation could also mean that the fund could experience a negative return during a market correction. Since the fund could see fluctuation in Net Asset Value (NAV) due to equity exposure, investors need to have an investment horizon of at least one year or more in such funds. Investors should ideally avoid parking funds meant for building an emergency corpus in this category as these funds carry a moderately high risk. There are 21 Conservative Hybrid Funds in the industry managing assets worth Rs 20,825 crore as of February 2022.
2) Balanced Hybrid
These funds maintain equity exposure in the range of 40 to 60%. Similarly, the debt portfolio can swing from 40% to 60%. As per Securities and Exchange Board of India, arbitrage is not permitted in this category. As compared to the earlier category (Conservative Hybrid, 10-25% equity allocation) you can see that the equity exposure is on the higher side (minimum 40% and maximum 60%) in the Balanced Hybrid category. Consequently, Balanced Hybrid Funds have the potential to generate relatively higher alpha and at the same time come with the risk of volatility associated with equity. This category hosts 33 funds with assets of Rs 1.46 lakh crore. Investors should have at least three years time horizon in this category.
3) Aggressive Hybrid Fund
As the name suggests, these funds take a higher exposure to equity. They can invest a minimum of 65% in equity and which can go up to 85%. They can invest between 20% to 35% of total assets in debt. Due to higher allocation to equity, these funds have the potential to generate higher alpha as compared to Balanced Hybrid category but they can also be susceptible to higher drawdown. Investors should have three years or more time horizon while investing in this category.
4) Dynamic Asset Allocation or Balanced Advantage Fund
These funds have the leeway to manage their equity and debt exposure as the fund manager deems fit. The asset size of this category has grown by more than 120% since the March 2020 crash. These funds adjust their equity allocation based on market valuations by using metrics such as Price to Earnings Per Share (PE) and Price-to-Book (PB) level of the broader index like the Nifty 500 or S&P BSE 500. When markets are overvalued, these funds reduce their equity exposure and increase allocation to debt and vice versa. Some funds invest directly into stocks while others are structured as Fund of Funds which invest in other or in house equity and debt schemes. Investors in this category should ideally have an investment horizon of at least three years and above.
Should you invest in Dynamic Asset Allocation Funds/Balanced Advantage Funds?
5) Multi Asset Allocation
These funds have an allocation to three asset classes such as equity, debt, and gold with a minimum allocation of at least 10% each in all three asset classes. The advantage of having gold in the portfolio is that it has a negative correlation with equities. Correlation helps us determine how two investments move in relation to each other. A correlation of +1 means that two investments move in line with each other, whereas a perfect negative correlation of -1 means that the prices of two investments move in the opposite direction. During the March 2020 crash, gold outshone other asset classes. Investors should note that though these funds need to maintain a minimum of 10% in each asset class, these funds can have a high allocation to equity depending on the prevailing valuations. For instance, some funds in this category are currently having an allocation ranging from 50% to 70% in equity.
6) Arbitrage Fund
These funds take arbitrage positions in equity and related instruments for at least 65% of the portfolio. The remaining corpus is mostly in high-quality fixed-income instruments and cash and equivalents. Arbitrage Funds aim to capture the price differential between the spot and futures markets, to generate returns. Investors with a horizon of over 3 to 6 months, can invest in this category, particularly during volatile periods. These funds generally have an exit load of 3 to 6 months. These funds are categorised under equity funds and thus have favourable taxation in comparison to say Liquid Funds. For holding periods of 1 to 3 years, gains in Arbitrage Funds are taxed at only 10% (only excess gains above Rs 1 lakh are taxed), compared to 30% for the highest tax bracket investor.
What are Arbitrage Funds?
7) Equity Savings
These funds invest a minimum of 65% of total assets in investment in equity, arbitrage, and a minimum of 10% in investment in debt. These funds are more tax effective as compared to Conservative Hybrid Funds as they are categorised as equity funds. These funds aim to provide moderate capital appreciation through equity coupled with a steady income through debt and arbitrage portfolio. The ideal investment horizon in such schemes should be one year or more.
Taxation
Debt
Conservative Hybrid Funds attract debt funds taxation since a predominant portion (minimum 75%) is invested in debt securities. If you are investing in a Dynamic Asset Allocation or Balanced Advantage Fund which is structured as Fund of Fund, you will attract debt fund taxation.
- Long term capital gains (LTCG) tax: 20% (plus surcharge, if applicable and cess) with indexation if held for more than 36 months
- Short term capital gains (STCG) tax: Income tax slab rate if held for less than 36 months
Equity
Equity Savings Funds and Arbitrage Funds attract equity funds taxation. If you are investing a fund that invests a minimum of 65% in directly in stocks, it will attract equity funds taxation, which is 10% tax on gains of above Rs 1 lakh while short term capital gains are taxed at 15% plus surcharge.