You can typically find two types of investors in the capital market.
The first category is the risk-taker. These investors invest in highly volatile equity mutual funds. Since equity is the most volatile instrument, the opportunity for rapid capital growth is considerably high.
The second category is the risk-averse investor. A risk-averse investor invests in debt funds since, unlike equity, debt funds offer stable returns. Also, debt funds typically deliver higher returns than conventional fixed deposits.
However, besides the two investor types mentioned above, there is another type of investor. These investors prefer getting the best of equity and debt by investing in hybrid funds. The following sections explain what is hybrid fund, its types, benefits, disadvantages, features, and more. Read on to find out.
What is a Hybrid Fund?
A hybrid fund is a special type of mutual fund that allows you to invest in two or more popular capital and commodity market instruments. While equity and commodity are meant for speeding up capital growth, debt ensures stability and excellent risk management. The primary objective of a hybrid fund is to provide you with capital appreciation sans the risks of pure equity funds.
Equity and debt share a low correlation, which is why hybrid funds outperform when pure equity funds enter the bear territory (read, decline). Conversely, hybrid funds might deliver stellar returns when the equity market shows a steady recovery.
Equity stocks and debt instruments generally move in opposite directions. This is because when the equity market grows, investors pull out funds from debt and pour them into equity stocks, thus propelling equity stocks to become more valuable. In contrast, investors shift to debt if the equity market declines to protect their capital while earning decent returns.
So, hybrid funds can allow you to get the most of equity and debt and reduce the risks associated with capital market investments.
What are the Types of Hybrid Mutual Funds?
The following are the four most popular types of hybrid mutual funds in India:
- Aggressive - These funds invest around 65% of the Asset Under Management (AUM) in equity stocks and equity-related instruments and the remaining in debt instruments. The debt instruments can be corporate bonds, government securities, commercial papers, certificates of deposit, non-convertible debentures, etc.
- Conservative - Unlike aggressive hybrid funds, conservative funds invest around 75% of their AUM in debt instruments of top public or private institutions. It invests the remaining in equity and equity-related instruments. Conservative hybrid fund returns are generally lower than aggressive funds since debt instruments are always less volatile than equity stocks.
- Multi-Asset Allocation - These funds invest in three different asset types with a minimum of 10% in each asset class. These funds are good for diversification and risk management.
- Balanced - Balanced funds invest between 40% and 60% in both debt and equity. The primary objective of these funds is to provide long-term capital growth and reduce the risks of capital loss.
Advantages of Investing in Hybrid Mutual Funds
The following are the top advantages of hybrid funds:
- Explore Multiple Asset Classes - The most prominent advantage of a hybrid fund is that it allows you to open one account to invest in multiple asset classes, such as equity, debt, commodities, and even derivatives.
- Reduce Risks - Mutual fund houses design hybrid funds such that they deliver decent returns without much risk. They achieve this through portfolio diversification.
- Diversification - Hybrid funds divide the AUM into sub-asset classes within the master asset class. For example, an aggressive fund with 65% exposure to equity may invest in large, mid, and small-cap stocks. Similarly, a conservative fund may invest in corporate and government bonds.
- Suits All Investors - Hybrid funds suit both aggressive and conservative investors. People looking for stability and higher returns than FD can also invest in these funds.
- Fund Manager's Expertise - Hybrid fund managers restructure portfolios depending on the market structure. If the equity market displays weakness, fund managers shift the investment into debt and vice versa. Since the fund manager does the portfolio rebalancing, you don't have to do it yourself.
Disadvantages of Investing in Hybrid Mutual Funds
The following are the top disadvantages of hybrid mutual funds:
- Market Risks - Since the equity market is highly volatile and hybrid funds have exposure in equity, they carry market risks. Any fall in stock prices may also reduce your fund value.
- Credit Risk - If a hybrid fund chooses debt instruments with low credit ratings, the chances of default will be high. If a company defaults on the repayment of interest and/or principal, the fund value may decline substantially.
- Interest Rate Risk - Bond prices are inversely related to interest rates. If the interest rates increase, bond prices fall. This can cause a reduction in the fund value.
- Not Choosing the Right Fund - Investors often look at the past performance of a hybrid fund before investing. However, past performance is not an accurate indicator of future performance. Hence, you must evaluate the fund's portfolio, weightage on equity and debt, and macroeconomic conditions.
- No Control - While you can analyze the portfolio to choose the best hybrid fund, you cannot control the equity or debt instruments directly or indirectly. Hence, you must trust the good judgment of the fund manager to invest in a fund.
Hybrid Mutual Funds - Tax Implications
When you invest in a hybrid mutual fund, you may have to pay three types of taxes. They are as follows:
- Long-Term Capital Gains Tax (LTCG) - LTCG is different for equity and debt funds. For equity-oriented hybrid funds, LTCG applies to profits made after one year from the investment date. For debt-oriented hybrid funds, LTCG applies to profits made after three years from the investment date. The LTCG for equity funds is 10%, and the LTCG for debt funds is 20% (with indexation).
- Short-Term Capital Gains Tax (STCG) - Like LTCG, STCG is taxed differently for equity and debt. For equity, the STCG rate is 15%. But, for debt, the profits are added to the investor's net income and taxed accordingly.
- Dividend Income - If you opt for a hybrid fund's IDCW or dividend payout scheme, you have to pay taxes on the dividend. The dividend will be added to your net income and taxed accordingly.
Hybrid mutual funds are an excellent investment option to earn decent returns without much risk. However, before investing in a hybrid fund, you must evaluate its expense ratio and the fund manager's profile. The expense ratio reduces the actual returns since the fee gets automatically deducted from your account. Also, a fund manager with a proven track record of profit-making has a higher chance of delivering good returns. Hence, evaluating the pros and cons of hybrid funds is a must before committing to them.