Invest in hybrid MFs to reduce equity risk

Hybrid funds give you a mix of equity-linked growth along with the safety of debt investments. Here is a primer on them. Mutual funds are selling at record highs. They are popular among investors, due to the simplicity of investment and redemption, and the possibility of high yield. Mutual funds cater to a variety of investment needs or risk appetites. Investors with a high risk appetite, who want market-linked returns, choose equity mutual funds while investors with a low risk appetite choose debt mutual funds.  Then there are investors who fall between those two ends of the spectrum: those who seek the safety of debt funds mixed with the possibility of equity-linked returns. A hybrid mutual fund is the go-to instrument for such investors.

Let’s understand what hybrid funds are and how they work.

What are hybrid funds?
Hybrid funds invest in both equity and debt in a proportion determined in line with the objective of the fund. For instance, an equity-oriented hybrid fund invests primarily in equity, while a debt-oriented hybrid fund invests primarily in debt. The funds are rebalanced continuously to adhere to the predetermined equity and debt allocation. Hybrid funds, with exposure to both equity and debt, have lower risk than the pure equity funds and the possibility of higher long-term returns than debt funds. They do well when the stock markets are rising due to their underlying equity assets, and they hold up when the markets are falling due to the cushioning provided by their debt components.

What are the different types of hybrid funds?
Hybrid funds are primarily of two types: Equity-oriented mutual funds, also called balanced funds, and debt-oriented hybrid funds which are further sub-divided into conservative funds, moderate funds and aggressive funds.

As the name suggests, equity-oriented hybrid funds, also known as balanced funds, have a higher equity exposure with the minimum exposure of equity at 65 per cent at all points of time. This level of exposure can be increased momentarily depending on the fund manager’s investment strategy, but the accumulated corpus is re-balanced at the end of the day to regain the pre-determined allocation proportion.  

Say a fund is invested in equity and debt in a 70:30 proportion. So, if you invest Rs 10,000 in that fund, Rs 7,000 would go to equity and Rs 3,000 would go to debt. Now, if the fund grows to Rs 10,500 at the end of the day, your investment would be rebalanced to achieve the 70:30 ratio. So Rs 7,350 would have to be re-allocated to equity and Rs 3,150 to debt.

These funds have an equity exposure ranging from 10 to 30 per cent with the rest of the portfolio invested in debt instruments of different types. These funds are further sub-divided into three heads based on their equity exposure:

Rebalancing is done in these funds as well. Debt-oriented funds are usually offered as monthly income plans (MIPs), as they pay a non-guaranteed dividend depending on the growth of the fund.

Hybrid Funds and Taxation
Equity-oriented hybrid funds are taxed like equity mutual funds. Proceeds on redemption after 12 months are called Long-Term Capital Gains (LTCG) and are tax-free. Proceeds on redemption before 12 months are called Short-Term Capital Gains (STCG) and are taxable.

Debt-oriented hybrid funds are taxed like debt MFs. Redemption after three years qualify as LTCG and are taxed at 20 per cent with indexation benefits. Proceeds on redemption before three years are treated as STCG and taxed at your income tax slab rate.

Benefits of Hybrid Funds

Hybrid funds are preferred by individuals as they give you the best of both worlds — low-risk and high returns. Market reports suggest that hybrid funds have outperformed the Sensex a few times in the past decade.

Besides fetching higher returns, hybrid funds, through their rebalancing feature, also help in booking your profits by maintaining the allocation between equity and debt. Moreover, hybrid funds usually invest in top performing equity and debt instruments which promise you the highest growth. Thus, these funds are an effective option, if you do not want the hassles of investing and rebalancing a basket of products in a regular basis.

The writer is the CEO of BankBazaar.com