For a long period of time, most retail investors in our country associated mutual funds only with equity investments. In Advisorkhoj, we get a large number of mutual fund related queries from investors every week. We have seen that, around 70% of the queries are related to equity mutual funds. However, over the past three years, we have seen a lot of interest in other asset categories like debt funds, hybrid funds etc. This is a very encouraging development because mutual funds can provide solutions to a wide variety of investing needs. A few months back, we published a series on debt funds, to improve knowledge about fixed income investing and awareness of debt fund products. In this series of articles, we will discuss about hybrid funds, their characteristics, benefits and different type of hybrid funds.
A hybrid fund is category of mutual funds whose underlying portfolio comprises of a mix of equity or equity related securities, debt or fixed income securities and money market instruments. Sometimes hybrid funds can be fund of funds, i.e. a scheme which invests in other mutual fund schemes, but the underlying portfolio of the funds in a hybrid fund of funds will comprise of equity, debt and money market securities. Equity or equity related securities are shares of companies and derivatives (for hedging). Debt securities include Government bonds of varying maturities and corporate bonds (sometimes called non convertible debentures). Money market instruments include Treasury Bills, commercial papers, certificates of deposit etc.
Each of these asset categories (equity, debt and money market) has different risk, return and liquidity profiles. The combined risk / return characteristics of a hybrid fund will be determined by the allocation percentages of each asset category in the fund. Different hybrid funds have different risk / return characteristics depending on the relative proportions of the different asset categories and as such, different types of hybrid funds can provide effective investment solutions for a variety of investment needs and risk capacities.
We have discussed the importance of asset allocation a number of times in our blog. Asset allocation is the percentage mix of different asset classes like debt, equity, gold etc in your total asset portfolio. However, we have seen that, many investors ignore asset allocation in their investment planning. A sub-optimal asset allocation may compromise your financial planning by putting your goals in danger.
For example, if your asset allocation is heavily weighted towards equity and you are approaching an important financial goal, a sharp downturn in stock market will cause your portfolio to lose a lot of value and may not recover when you need the money. On the other hand, if you are too light on equity and have most of your money invested in fixed income (debt) then you may fall short of your financial objective because fixed income returns may not be sufficient in helping you achieve your goal. Optimal asset allocation enables you to take the right amount of risk and get adequate returns to meet your financial goals.
Optimal asset allocation differs from investor to investor depending on their age, risk capacities and financial situation. Depending on how sophisticated you want to be with your asset allocation, you can have a bespoke asset allocation strategy (working with a financial planner) or follow simple rule based asset allocation strategies. A popular asset allocation strategy is the Rule of 100; simply subtract your age from 100 and the result should the desired equity allocation in your portfolio (the balance allocation will be in debt / money market). So if you are 30 years old, your equity allocation should be 70% and your debt allocation should be 30%.
You can construct this optimal asset allocation portfolio by allocating 70% of your money in equity mutual funds and 30% in debt mutual funds. You need to have good understanding of debt funds in order to select the appropriate fund(s) for your portfolio because different types of debt funds have different risk (interest rate risk and credit risk) characteristics. On an ongoing basis, you have to monitor both equity and debt funds investment performances. From time to time you also need to rebalance your portfolio because your portfolio asset allocation will deviate from the optimal asset allocation over a period of time (we will discuss this in more details later).
If you want to avoid the hassle of managing your equity and debt portfolio yourself, you can invest in a hybrid fund, which has the same (or nearly the same asset allocation). For example, if your optimal asset allocation is 70% equity and 30% debt, you can invest in balanced funds, a type of hybrid fund, which usually has 65 – 75% equity allocation and 25 – 35% debt allocation.
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If your optimal asset allocation is 20 - 30% equity and 70 - 80% debt (some senior citizen investors may prefer such an asset allocation), then you can invest in aggressive monthly income plans (MIP), another type of hybrid fund, which usually has a similar asset allocation profile. If you want a more conservative asset allocation, you can invest in conservative monthly income plans, which have a lower allocation to equities.
If your asset allocation profile is somewhere in between of the different ranges discussed you can pair two or more hybrid fund with different asset allocation profiles in the necessary proportions to get to your target asset allocation. For example, if your desired asset allocation is 50% equity and 50% debt (many investors in the later stages of their careers may desire such an allocation), you can invest 60% of your money in a balanced fund which has 70% equity allocation and 40% of your money in an MIP which has 20% equity allocation; the combined asset allocation will be 50% debt and 50% equity. The percentages invested in different fund categories should be fairly simple to calculate; you can either use trial and error or just basic algebra to calculate the percentages.
Scheme names can give you clues about asset allocation of hybrid funds. For example, “balanced funds” usually have 65 – 75% equity allocation and 25 – 35% debt allocation. “MIP or Monthly Income Plans” usually have 5 – 30% equity allocation and balance debt allocation; aggressive MIPs have higher equity allocation, while conservative MIPs have lower equity allocation. While scheme name can give some clues regarding asset allocation, in our opinion, you should always check the current actual asset allocation of the fund, by looking up the scheme on mutual fund research websites like Valueresearchonline.com, Morningstar.in, Advisorkhoj.com, etc. You can also read the monthly funds factsheets to know the current asset allocation of hybrid fund schemes. You should know that, hybrid funds rebalance their asset allocation from time to time (more on that later). You should, therefore, also read the scheme information document to know the asset allocation ranges of a hybrid fund.
You may like to read a related topic here Optimize your asset allocation with balanced fund
In this post, we have discussed the basic characteristics and benefits of investing in hybrid funds. We have seen that, hybrid funds provide investment solutions for investors with moderate or low risk appetites, who want stable returns and limited downside risks. These funds are also suitable for investors who want regular income along with capital appreciation. As mentioned earlier in our post, there are different types of hybrid funds, which are suitable for specific risk appetites and investment needs. In the next few posts, we will discuss different types of hybrid funds in more details.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
Sundaram Asset Management Company is the investment manager to Sundaram Mutual Fund. Founded 1996, Sundaram Mutual is a fully owned subsidiary of one of India's oldest NBFCs - Sundaram Finance Limited.
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