What is a hybrid mutual fund?
Hybrid mutual funds allow one to invest in a combination of debt and equity. These can be further classified as equity hybrid and debt hybrid funds. In an equity hybrid fund at least 65% of the corpus is invested in equities and the rest in debt. The remaining corpus is invested in debt up to a maximum of 35%.The average month end equity exposure of a hybrid equity fund for all the twelve month ends of the year needs to be at least 65%for it to be classified as a equity hybrid fund. This helps an equity hybrid fund to gain tax benefits. Debt hybrid funds invest at least 75% in debt and the remaining amounts in equity.
Hybrid funds can be further divided as
- monthly income plans,
- asset allocation funds
- capital protection funds
These are designed for investors of different age groups and investment time horizons.
What are monthly income plans?
These are basically debt oriented mutual funds which invest 75-80% of the corpus in debt and the rest in equity .These funds can be further divided into a monthly income plan with a dividend option and one with a growth option, The dividend option helps to generate income in the form of dividends which are tax free in the hands of the investors. The dividend distribution tax needs to be paid by the Company distributing the dividends and ones return would reduce before it reaches his hands .In the growth option no dividend is paid .The amounts are reinvested in the fund itself. This increases the value of the fund and huge returns are obtained on liquidation of these funds .If the MIP is sold for a profit within a year it is called a short term capital gain. These amounts are added to ones income and taxed as per the income tax slab he falls under. Long term capital gains beyond a year are taxed at 10% without indexation and 20% with indexation whichever is lower.
What are capital protection funds?
A typical capital protection fund is a debt instrument .The debt oriented fund is close ended and has 80% in debt and 20% in equity. The huge proportion of debt ensures capital protection as it is close ended in nature and the equity component helps in gaining decent returns in the stock markets. These funds cannot use the word “guaranteed” or “capital protection” .They can only be called as capital protection oriented. These funds purchase “AAA” rated debt or debt of very high quality which helps the principal amounts grow over a fixed tenure. This protects the capital and the equity component generates returns far in excess of its proportion by investing in the options and futures market. An amount as less as INR 5000 can be invested in these schemes. These instruments are not suitable for an aggressive investor as they can sometimes give as less as 5% returns over a 2-3 year time horizon.
What are asset allocation funds?
Another word for asset allocation is diversification .These invest across a wide variety of financial instruments such as cash, equity debt and even money market instruments .Different financial instruments are affected by different macro economic conditions. A rise in interest rates in the economy ensures that newly launched debt gives a high yield. The rise in interest rates can affect interest rate sensitives such as banks, automobiles and infrastructure firms in the equity sector. The benefits of diversification provides a balancing factor by evening out profits and losses. In a normal asset allocation the effects of rebalancing or churning a portfolio to take advantage of changing economic and market scenario is offset by a high tax .This does not occur in an asset allocation mutual fund where the fund manager can easily churn the portfolio taking advantage of the changing economic scenario and not worry about the tax aspects. Asset allocation funds can be divided into tactical asset allocation funds and lifestyle funds. Under a tactical asset allocation fund the manager continuously monitors the fund and makes changes in accordance with the market movements in order to generate huge returns for the investor. In a lifestyle fund investments are made based on the age group of an investor. An allocation of 65% is made towards equity and 35% towards debt. If equity markets do well this balance is disturbed in favor of equity. Some quantity of equity is sold in order to rebalance the portfolio.
Why should one invest in a balanced or hybrid mutual fund?
First time investors in the stock market and investors in non equity who want to try their hand at the Indian stock markets look at hybrid mutual funds mainly equity hybrid mutual funds as a method of investment. With 65% equity in them these funds have a high exposure to equity .It also has a debt element which protects it from the downsides in the market .In a pure equity diversified fund there is no debt element or a safety net. In times of high returns in the market there is a huge upside potential and when the markets collapse these funds are impacted heavily. This causes extreme panic to the first time investors who exit the markets at this time incurring heavy losses. Hybrid funds give steady returns across all market cycles and are preferred by conservative investors. This protection from volatility endears them to the conservative investor’s .These funds are extremely useful when one wants to achieve financial goals with a 3-5 year time horizon .An investor can invest in an SIP of a hybrid mutual fund and create a huge corpus over a time frame of 3-5 years. Short term financial goals can be achieved using this method as the element of market risk is low.
What are the risks involved in a hybrid fund?
Many fund managers invest in corporate bonds which mature in line with the tenure of these funds. These corporate bonds may have a default or a credit risk .This basically means there is a chance of default by these corporate bonds on the interest and principle components. Government bonds are highly secure and can never default. The same cannot be said of a Corporate bond. Hybrid funds invests in “AAA” rated securities which are deemed highly safe and the chance of a default is low. These companies are rated regularly by credit rating agencies .However defaults can occur and this creates an element of risk for a hybrid fund. The funds are subject to market risk. A fund manager invests or churns the portfolio based on certain expectations in the market. If these expectations are matched by suitable economic conditions then returns are high. If not then market risk based on factors beyond his control such as an increase in interest rates, exchange rate fluctuations or political uncertainty can impact returns.
How are the returns generated by a hybrid mutual fund?
Hybrid mutual funds generate decent returns when markets are in an upswing .In the last few years since 2009 balanced funds have been giving a good return. They average returns over 15% in the last 3-4 years. This was in comparison with over 20% generated by the stock markets .However their true power lies in providing a cushion when markets fall. These funds generally do well when markets are falling. Hybrid debt funds with only about 25% exposure to equity are not seriously impacted by a fall in the markets when compared to an equity hybrid fund. An equity oriented hybrid fund has a 65% exposure to equity and when the markets crash share prices fall down .This shortfall has to be made up with the purchase of additional shares .When the market rises the shares price would rise and the fund manager would indulge in profit booking and purchase debt .This would reduce the risk in these funds.
What are the tax aspects of hybrid mutual funds?
- Equity oriented hybrid schemes have over 65% invested in equity .Short term capital gains arising out of redemption under a year are taxed at 15.45%. There is no taxation on long term capital gains of an equity hybrid fund if the holding period is over a year.
- For a debt hybrid fund short term capital gains are added to the taxable income and taxed as per the income tax slab one falls under. Long term capital gains are taxed at 10% without indexation and 20% with indexation. Indexation is basically adjusting the purchase price for inflation. This reduces the capital gains and effectively the tax liability is curtailed.
I would like to end this article stating that a hybrid fund is most suitable for a conservative investor because its debt portions cushion the impact of a fall in the market. However this financial instrument does not give a true picture of the actual impact of investing in the stock markets .A beginner who wants to invest in the stock market needs to have a small portion of his corpus in an equity diversified mutual fund in order to actually experience the thrill of investing in stock markets.
The main fear one has of investing in the stock market is the loss of all that is invested. All or nothing is the perception one has of the stock market .In the hope of gaining an extra shirt one might lose his trousers .But is this true? Is it not possible to play safe in the stock markets? Can a conservative investor look to the stock markets as a source of good returns cutting down the risk element? Hybrid mutual funds also called balanced funds might just be the solution to the problem.