How to Choose the Best Hybrid Fund?

If you really want a kind of a compromise between equity funds and debt funds, the answer lies in Hybrid funds. Hybrid funds, as the name suggests, are a combination of equity and debt and at times even more than that.

What exactly does a Hybrid Fund do?

Here are some of the highlighters that you need to remember about hybrid funds in the Indian context.

• These hybrid fund invests in multiple asset class. They would typically look at various permutations of debt and equity based on risk appetite.
• Hybrid funds are auto diversifiers. The investor does not have to exert about how to diversify the risk. The portfolio structure of hybrids do it for you.
• Hybrid funds are categorized into 7 distinct classes, including balanced, aggressive, conservative, equity savings, multi-asset allocation, dynamic allocation and arbitrage.
• Taxation of hybrids is based on the mix of equity and debt. Typically, if the equity component is above 65% it will be classified as equity funds and taxed accordingly
• The recent NFO of Balanced Advantage Fund by SBI Mutual Fund ended with record collections for any fund in history at nearly Rs.14,600 crore.
• A dynamic fund is typically giving more discretion to the fund manager about deciding on the idea mix of asset classes and the flexibility to modify them.

Are Hybrid Funds risky?

Remember that in investing, risk is always relative and never absolute. For example a hybrid fund is riskier than debt funds but less risky than equity funds. Similarly, an aggressive hybrid fund is riskier than a conservative hybrid fund, which in turn is riskier than an arbitrage product which is more of a treasury product, although it is still classified as a hybrid fund due to the asset class mix.

There are two important roles that hybrid funds play. Firstly, they are auto allocators so the individual investor does not have to worry about where to invest and how to invest. That allocation decision is entirely done by the hybrid fund manager. The second advantage is that hybrid funds are also auto diversifiers as the mix of different asset classes ensures adequate diversification across asset classes and time frames.

In short, the equity portion gets good returns, albeit at some risk. Simultaneously, debt instruments in the fund's portfolio offer regular income. You may wonder why a hybrid fund works with this combination of asset classes? The answer is low correlation between asset classes like debt and equity, which reduces downside risk substantially. It sort of gives the best of both worlds.

How do you differentiate between the various classes of Hybrid Funds?

SEBI has given a detailed prescription of what each of the categories of hybrid funds should comprise of. There are 7 such categories of hybrid funds that hav been hybrid funds.

1. Balanced Hybrid Funds approximately balance their holdings in equity and debt and as the word suggests, they are actually funds with a balance between debt and equity. Typically, the equity and debt components in these funds range between 40% and 60%. So a balanced fund can be 40% in equity and 60% in debt or vice versa or it can be any combination in between. The purpose of investing in balanced hybrid fund is capital appreciation in the long-term while balancing the risk with debt in short term.
2. Arbitrage Funds are actually treasury products but have bene classified as hybrid funds by SEBI due to the mix of equity, futures and debt that these funds typically deploy. An arbitrage fund typically sells a stock in the equity market and sells equivalent futures in the F&O market so that the premium on futures is locked in as assured profits. Since futures are leveraged products, chunk of the corpus of such funds are invested in equities and hence they will be classified as equity funds for the purpose of taxation. Fund manager leverage volatility of cash and futures market. Typically, cash holdings will be above 65% and the balance in futures margins with positive spread.
3. Equity Savings Funds are a combination of equity, debt and futures & options and are an extension of the arbitrage fund. The only difference is that these are not treasury products but they use futures to enhance returns. These are again equity funds as per the tax levy classification.
4. Conservative Hybrid Funds would normally invest between 10% and 25% of the total corpus in equity and the balance 75-90% in debt. That is why they are called conservative as they are predominantly debt funds but just a small part of the corpus is in equities so that the additional alpha can be generated. Such funds typically have the objective of regular income for investors due to strong debt exposure.
5. Aggressive Hybrid Funds can be seen as the counterimage of conservative hybrids. Such Aggressive hybrid funds will typically have between 65-80% in equity and the balance in debt. This small component provides some stability and balance to the predominant equity exposure. These funds tend to outperform conservative hybrid funds in terms of returns, although risk is also higher.
6. Multi-Asset Allocation funds are not too common in India but they combine at least 3 asset classes into a single fund. For example, equity, debt and gold is a classic combination of a multi-asset allocation fund with predominant focus on either of them. The only condition is that each of these should be at least 10%. Of course, gold, equity and debt tend to be uncorrelated largely and that helps in risk diversification.
7. Dynamic Asset Allocation the last of these became extremely popular after the record NFO collections of Rs.14,700 crore in the SBI Balanced Advantage Fund. These are based on discretion of the fund manager and the allocations can go from 0% to 100%in debt and from 0% to 100% in debt. That is theoretical, but in practice, most of the BAFs do keep a bare minimum in both asset classes as matter of internal policy.

What exactly are the benefits of a Hybrid Fund?

Here are some of the advantages that you derive by investing in hybrid funds.

• They offer a formula driven approach to investing in different asset classes. Investors don’t need to exert themselves about how to diversify. Such hybrid funds offer actual hybrid packages and investors can pick and choose what they want.
• That needs no reiteration that diversification of risk is a major advantage of these hybrid funds. After all, fund managers can diversify across asset classes, maturity classes, quality classes, capitalization classes etc.
• Appeals to different risk appetites like aggressive investors, conservative investors, dynamic investors etc. There is a solution and answer to all your needs of mixing debt and equity.
• Should you choose, you can also give more leeway to the fund manager by opting for dynamic allocation funds. Of course, this comes with the risk of personal bias of fund managers and you need to be cautious about the same.

How are Hybrid Funds taxed in India?

The Income Tax act only differentiates between equity funds and non-equity funds. Any fund with more than 65% holdings in equity is classified as an equity fund for tax purposes. Hence an equity fund will be classified as equity for tax purposes. That means any hybrid fund (aggressive, equity savings, arbitrage are all classified as equity funds for tax purposes). Here is what it means in terms of tax implications.

• Equity funds gains will be short term if held for less than 1 year and it will be long term if held for more than 1 year.
• In the case of short term capital gains on equity funds, they will be taxed at a concessional tax rate of 15% on the STCG. However, this will be subject to any cess and surcharge applicable from time to time.
• In the case of long term gains on equity funds, the first Rs.1 lakh of gains for the entire equity category will be exempt. Any gains above that will be taxed at a flat rate of 10%, without any indexation benefits.
• Short term capital losses on equity funds can be set off against long term and short term gains. However, long term capital losses can only set off against long term gains. Such losses can be carried forwards for 8 years if not absorbed fully in current year.
• Dividends on equity funds and debt funds are now treated as other income in the hands of the investor and taxed at the peak applicable incremental rate of tax.