Hybrid funds invest in three kinds of asset classes — debt, equity and gold. According to the Securities and Exchange Board of India classification, there are six categories of hybrid fund. An aggressive equity hybrid fund, earlier known as balanced fund, invests around 65% -75% in equity and remaining debt funds. Funds in this category can be flexi-cap (either small-cap or mid-cap category).
Dynamic asset allocation or balanced advantage fund can put up to 100% in equity or debt. Here the fund managers can alter the composition. Since the fund managers can change the composition based on market conditions, this category is slightly less volatile. And based on the composition, the taxation varies.
In multi-asset fund, you will have allocation in all three asset classes. The equity allocation is around 65%, debt 20% to 25% and the remaining in gold.
In equity savings funds, the equity component can range between 10% and 40% while the rest is in arbitrage and debt funds. It has lesser longer term equity so are less volatile and attract equity taxation.
In case of debt hybrid funds or conservative hybrid funds where fund managers are managing the fund, a lot depends on the interest rates to alter the composition. In debt hybrid fund, around 75-85% of the corpus is invested in debt. The fund attracts debt taxation as there are no arbitrage funds.
Balanced hybrid funds are mandated to invest 40-60 per cent in debt or equity is still not popular among mutual fund investors and advisors. Mutual fund advisors list reasons like taxation, Sebi’s stringent norms, lack of open-ended schemes, among others, as to why these schemes have not found favour among the mutual fund community.
Many mutual fund participants point to the taxation of balanced hybrid schemes as the biggest damper that is harming the cause of these schemes. These schemes would be treated as debt schemes for the purpose of taxation. A mutual fund scheme should invest at least 65 per cent in Indian stocks to be treated as an equity mutual fund scheme for taxation.
Hybrid balanced category can go to maximum 60 per cent in equities. Investors argue that if going 5 to 10 per cent extra in equities can provide them with the taxation benefits, why they would go for the balanced category which follows the taxation of debt.
Gains in balanced hybrid funds held for less than three years are treated as short term capital gains and will be added to the income and taxed as per the income tax slab applicable to the investor. Long term gains on units held for more than 36 months are taxed at the rate of 20 per cent after providing for indexation.
Equity schemes have a favourable taxation regime in comparison. If equity mutual funds are held for more than a year, they qualify for long-term capital gains tax of 10 per cent. Gains of up to Rs.1 Lakh in a financial year are tax-free. If these schemes are held for less than a year, gains are treated as short term capital gains and are taxed at 15 per cent.
However, the catch with hybrid funds is that even though two funds are in the same category, it does not mean they are similar. They may have starkly different portfolio construction with varying investment allocation.
The way the investment portfolio is constructed, defines the volatility and risk profile of the fund. For example, Mirae Asset Hybrid Equity fund invests 90% to 95% of its equity portion into large cap and most of its debt portion in short duration funds to reduce volatility. On the other hand, L&T Hybrid Equity fund invests 50% of its equity portion in small and mid-cap companies and the balance in large-cap companies. Now depending on the market volatility either of the funds performance will differ.
Even though they are in the same category, their volatility is different. If the duration of the instruments is higher, it will be more volatile than the debt funds of a shorter duration of the same category. Hence, it is important to monitor the portfolio composition in hybrid fund. For instance, in a conservative hybrid fund, just because it is conservative it is not essential that the debt papers it invests in will be conservative.
All mutual funds attract charges in the form of expense ratio. If you look at any category of hybrid fund and compare it with buying a debt or an equity fund separately, the latter option will turn out to be cheaper than buying a single hybrid fund. Let’s assume the expense ratio for equity funds is 1.75% (a mid-point of the range 1.5 to 2%) and expense ratio for a debt fund is 0.5% (a mid-point of the range 0.5 to 1%) while for a balanced advantage hybrid fund is 1.75% (a mid-point of the range 1.5 to 2%). Say you invested ₹1 lakh. The cost for the hybrid fund will be ₹1,750.
For instance, if you invest ₹50,000 in a debt fund where your expense would have been ₹375 and ₹50,000 in an equity fund where your expense would be ₹875, then your total expense would be ₹1,250. This difference in amount shows the advantage of keeping your funds separately.
If you are investing in hybrid funds, it is assumed that you are looking for lesser risk. It works for first time investors and for those who are not looking to handle their own asset allocation.
First-time investors, who can’t handle the volatility of equity or debt funds can look at hybrid funds. Investors who don’t do their asset allocation and are comfortable with fixed allocation, can look at hybrid funds.
You should look at factors such as returns, volatility, your tax slab and risk profile. It’s not possible for you to expect zero volatility because almost all funds will have equity exposure.