Hybrid Mutual Funds

Hybrid funds are those that invest in at least two different asset classes to offer diversified investment portfolios. Most hybrid funds feature equity and debt as the asset classes in varying proportions based on the type of hybrid fund.

Most hybrid funds are considered to be moderate risk investments because of considerable allocation to debt or fixed income instruments which have lower risk than equity. 

Let’s look at the various aspects of hybrid mutual funds like types of hybrid funds, their advantages and taxation applicable.

In 2017, SEBI recategorised the entire mutual fund universe. Allocation rules were put in place to ensure that mutual fund schemes across categories stayed true to their mandates and there was minimum overlap among different categories. To help investors monitor and manage this, our Portfolio Overlap Tool can be invaluable in identifying and avoiding undue overlap in their mutual fund holdings.

Likewise, hybrid funds were categorised based on two factors:

1. Number of asset classes they can invest in
2. Allocation rules for each asset class

Conservative Hybrid Funds

As the name suggests, conservative hybrid funds take a conservative approach to investing. They are required to invest 75-90% of their assets in debt instruments at all times, with the remaining 10-25% in equity.

As per AMFI: As of Sep 2023, 20 conservative hybrid funds manage about ₹25,000 crore in India.

Balanced Hybrid Funds

Balanced hybrid funds invest roughly half of their assets in debt instruments and equity each. As far as the rules go, they are required to invest a minimum of 40% and a maximum of 60% in debt instruments as well as equity at all times.

Note: Balanced hybrid funds are different from balanced advantage funds (discussed below)

Aggressive Hybrid Funds

Aggressive hybrid funds are equity heavy and suited for investors who have a high risk tolerance. They are required to invest 65-80% of their assets in equity at all times, with the remaining 20-35% in debt instruments.

As per AMFI: As of Sep 2023, 31 balanced and aggressive hybrid funds manage about ₹1.75 lakh crore in assets.

Dynamic Asset Allocation or Balanced Advantage Funds

Dynamic asset allocation or balanced advantage funds are among the most popular mutual fund categories in India managing about ₹2.15 lakh crore assets as of Sep 2023.

This is because they do not have any restrictions and are among the most flexible mutual fund categories. Equity as well as debt allocation can be anything from 0-100%.

Multi Asset Allocation Funds

While other hybrid fund categories have defined equity and debt allocation ranges, multi asset allocation funds are required to invest in a minimum of 3 asset classes with a minimum 10% allocation to each.

This gives multi asset allocation a lot of flexibility as well as the ability to invest in multiple asset classes unlike other hybrid fund categories.

As of Sep 2023, 16 multi asset allocation funds manage just over ₹42,000 crore in assets. Source: AMFI

Equity Savings Funds

Equity savings funds are required to invest a minimum of 65% in equity and related instruments and a minimum of 10% in debt instruments.

The unique feature of equity savings funds is that they are required to hedge their equity exposure using derivatives which limits the downside risk. Derivatives are considered to be equity related instruments.

As of Sep 2023, 22 equity savings funds manage about ₹21,000 crore in assets.

Arbitrage Funds

Arbitrage funds follow the ‘arbitrage investment strategy’ which involves simultaneous buying and selling of identical securities to generate the price difference as profit.

For example: An arbitrage fund may buy stocks of a certain stock at ₹100 on stock exchange A and sell them simultaneously on stock exchange B at ₹101 to generate the price difference ( ₹1 per stock) as profit.

Arbitrage funds are quite popular because they are low risk-low return instruments and enjoy equity taxation. Equity taxation (10% or 15%) is lower than the marginal income tax rate that is applicable on debt mutual funds and hence preferred by investors in higher income tax brackets (20% and above).

In-built diversification lowers risk

Diversification across asset classes makes your investments stable.

Hybrid funds have in-build diversification because most of them are required to have minimum allocations to equity and debt instruments.

This helps investors and even advisors manage investment portfolios with relative ease while keeping the portfolios simple. This also saves time and effort that goes into selecting the right debt and equity funds to create a well-diversified portfolio.

Better taxation than a mix of debt and equity funds

Note: This advantage applies to equity-oriented (more than 65%) hybrid funds only and assumes investor to be in a higher tax bracket (20%+)

Suppose you want to invest in a mix of debt and equity funds where your target equity allocation is greater than 65%. In this case, you are better off investing in an aggressive hybrid fund or an equity savings fund from the taxation perspective.

This is because equity-oriented hybrid funds enjoy equity taxation despite having a significant debt allocation.

Another advantage is that the asset allocation rebalancing becomes the fund manager’s job and not the investor’s or advisor’s thereby saving time and effort.

Strategies and asset allocation may not suit everyone

While the idea behind hybrid funds is logical, hybrid funds may not suit everyone. This is especially true for categories where asset allocation freedom is high.

For example: Dynamic asset allocation or balanced advantage funds can have any allocation across equity and debt ranging from 0% to 100%. An investor with a low risk appetite might not like it if the fund manager increases the asset allocation of his hybrid fund to, say, 80%.

Further, different hybrid fund managers may resort to different strategies for asset allocation, equity allocation - value investing vs. growth investing, debt allocation - credit risk vs. duration risk. Not all investors may be comfortable with the various strategies followed by a given hybrid fund.

Lower returns than equity funds

The significant allocation to debt instruments results in hybrid funds generating lower returns than pure equity funds over the long term.

However, the debt allocation also helps cushion the portfolio during times of market crashes which can temporarily wipe out a significant portion if the debt component were absent.

We know that over the long-term, equity tends to generate higher returns than debt instruments. Since hybrid funds invest in a mix of equity and debt, their expected returns are greater than pure debt funds but lower than pure equity funds.

Similarly, in the risk spectrum, hybrid funds fall between pure debt funds and pure equity funds.

Here are the 3, 5 and 10 year average returns of all hybrid fund categories:

Source: Value Research Online | For periods ending 1 Nov, 2023

Not all hybrid funds are taxed in the same manner. 

The tax rate on capital gains arising from hybrid funds depends on the holding period and allocation to domestic equity:

Note: The above is applicable to all investments in hybrid funds after 1 Apr, 2023