Your comprehensive guide to hybrid funds

Seismic shifts in debt fund taxation have pushed many investors into the relative tax safety of hybrid funds. But hybrid funds aren’t the simplest of categories to understand, whether it’s what these funds do or the risks and impact if you include them in your portfolio.

Given this, and the number of queries we receive from you on using hybrid funds, we thought it best to put down a comprehensive explanation on these funds. in this report – which you can keep for ready reference – we break down each hybrid fund category on the following points:

1. Where they invest and how their portfolios are structured
2. How they perform in returns and risk
3. Predictability in their asset allocation
4. How to use them in your portfolio

The one important caveat we have here – as we have always maintained, hybrid funds are NOT substitutes for debt funds. Every time you replace a debt fund with a hybrid fund, remember that you are increasing your equity allocation and risk.

This guide is to help you judge how much equity and additional risk you are introducing and therefore make a better decision instead of relying on taxes alone. This guide will explain only portfolio and performance of the categories. For taxation, refer to our mutual fund taxation guide.

Arbitrage funds

Where they invest: Arbitrage funds primarily invest in equity. However, they take derivative exposure on this entire equity. That is, the fund will invest in the same set of stocks in both the spot and the derivative market, using derivatives to take the opposite position. That leaves the portfolio with no equity that is open to market movement (a detailed explanation of how arbitrage funds use derivatives and earn returns is here)

Arbitrage funds also invest about 25-30% of their portfolio in debt instruments (or even sometimes in other debt funds) for multiple reasons:

• One, because they are hybrid funds and can hold  up to 35% in debt and equivalents.
• Two, because they need to maintain debt allocation for margin requirements on their derivative exposure
• Three, because they might not have enough arbitrage opportunities
• Four, because they might simply see debt returning better at times.

For tax purposes, arbitrage funds are treated as equity funds.

How they perform: Arbitrage funds returns are aligned with very short-term rates of debt markets. As these funds entirely hedge equity, they score very well on downsides and volatility. For these two reasons – returns and volatility, arbitrage funds are often compared to liquid or other very short duration debt funds.

The table below captures the average returns, volatility and downsides of arbitrage funds. Figures are average for the category.

Predictability in allocation: Arbitrage funds are fairly stable in terms of portfolio structure, with around 65-75% in equity that is hedged through derivatives with the remaining in short-term debt. The difference in returns between funds comes from expense ratios, the day-to-day market volatility that hedging cannot address, and the stock-derivative arbitrage.

How to use: Arbitrage funds can be used in the following ways:

• To hold money intended for very short-term periods of less than 1 year. They can also be used in emergency portfolios. They are not useful for long-term portfolios meant for wealth building – there are both other hybrid funds and debt funds that steal a march in returns.
• In terms of pure returns, arbitrage funds do not have any clear advantage over liquid funds; average 1-year returns for liquid funds are almost exactly the same as arbitrage. With short-term capital gains tax now at 20%, do not take for granted that arbitrage funds are more tax efficient than liquid funds or deposits, if you are in the lower tax brackets. Any investor can well mix liquid and arbitrage funds in their portfolio.

Conservative hybrid funds

Where they invest: SEBI rules mandate these funds invest between 10-25% in equity with the remaining held in debt instruments. That makes these funds primarily debt oriented – both from the portfolio perspective and for taxation.

But each fund takes a call on the extent of equity they take within the mandate. Considering the average equity exposure in the past two years for each fund, it has been as low as 10-12% for a few while others have stayed at the upper end of the range.

Within debt, though, funds can follow any strategy, hold any maturity, and any credit exposure as they see fit. For example, average maturity of July 2024 portfolios range between less than 1 year to 18.7 years. Not just that, a fund can switch between an accrual and duration strategy based on the rate cycle or decide to take lower credit for better returns.

How they return: Conservative hybrid funds deliver similar to debt funds, given that they are primarily debt by nature. While equity allocation provides some impetus to return, the relatively low allocation many funds sport minimizes the advantage. Risks in conservative hybrid come more from the debt strategy followed (duration, for example, can result in higher volatility) and the extent of equity allocation.

The table below summarizes average returns and loss probabilities of conservative hybrid funds over different timeframes. Figures are average for the category.

Predictability in allocation: Since SEBI rules cap equity allocation, conservative hybrid funds are stable in terms of portfolio asset break-up. Funds certainly can shift equity allocations based on market conditions and can differ from each other in equity exposure as well. But the range within which they can do so means that such equity shifts are not enough to materially alter the risk-return profile of the fund. Unpredictability comes more from a potential change in the debt strategy – similar to dynamic bond funds – which can impact the risk involved in the fund.

How to use: Conservative hybrid funds are generally avoidable, especially after the advent of equity savings funds. Their debt-like taxation detracts even more from their uses. If you are very keen on investing in these funds, use them as part of debt allocation and where your holding period is at least 2-3 years.

Equity savings funds

Where they invest: These funds, by SEBI rule, need to invest at least 65% in equity and at least 10% in debt. Unlike arbitrage funds that hedge their full equity exposure, equity savings funds only partially hedge exposure. Each fund decides the extent of hedging done in the portfolio, which changes based on equity market conditions. But typically, equity savings funds tend to hedge a good chunk of their portfolio and leave only a small portion open to market movements. 

How they return: Equity savings funds are not immune to market corrections. Though they use derivatives to limit volatility, steep market corrections can and have sent funds into losses – for example, the sharp 2020 correction saw losses of over 10-12% in many funds. However, these funds are able to tide over shallower corrections and overall volatility by and large is on the lower side in these funds.

The table below summarizes average returns and loss probabilities of equity savings funds over different timeframes. Figures are average for the category.

Predictability in allocation: Equity savings funds can generally be trusted to keep unhedged equity allocations on the lower side. But within the category, funds can differ quite drastically between each other. This impacts their volatility and downside containment, as well as return potential. The table below shows the maximum and minimum equity exposure and returns within the category.

Therefore, it’s important to know the differential between funds and to be aware that higher returns come with higher unhedged equity. It is not necessary that all equity savings funds are very low risk.

How to use: Equity savings funds are investor favourites for their equity-like taxation that comes with low risk.

• These funds are not full debt substitutes and should not be considered as debt allocation. See the table above for the extent to which they can fall – debt funds do not suffer similar declines and in periods of equity correction, would do a far better job at protecting your portfolio. It is only if your portfolio size is very small that makes it hard to hold separate debt funds can equity savings funds replace debt.
• Partial substitutes for debt allocation: You can replace some amount of your debt allocation with equity savings funds provided your timeframe is at least 1.5 years or more. If your portfolio is especially heavy on debt - above 20% - then equity savings funds are tax-efficient options that come with reasonable returns.
• As part of emergency portfolio or post-retirement portfolio: If you intend to run systematic withdrawals from these funds, start any such withdrawal after at least 2 years.

Balanced advantage/ dynamic asset allocation funds

Where they invest: Funds may call themselves either dynamic asset allocation or balanced advantage – both mean the same thing. These funds invest in equity, debt, and use derivatives to hedge equity exposure. But there are absolutely no rules on how much equity, debt, or derivative a fund holds. Funds can be very aggressive with little to zero hedging, very conservative with good allocations to both debt and derivatives or anywhere in between.

How they return: Since balanced advantage funds can widely range in their equity and derivative exposure, the returns differ widely between funds. These funds are far more volatile than equity savings funds and suffer from higher downsides. Market corrections can hurt these funds – the only difference is that the extent of impact is lesser than with pure equity funds. But then, returns are also higher, especially when equity markets are rallying and funds minimize hedging.

The table below summarizes average returns and loss probabilities of equity savings funds over different timeframes. Figures are average for the category.

Predictability in allocations: Balanced advantage funds are extremely unpredictable in how they allocate between equity, derivative, and debt. Each fund adopts its own methodology and market indicators to decide allocations.

So, for one, equity and derivative exposure will shift in a fund based on what equity markets are doing and the fund’s strategy. Second, each fund will differ from the others in its category even in the same market as funds have varying views on market outlook based on its methodology. Take current markets. The hedged portfolio ranges from no hedging at all to 37%. Clearly, views on how to manage markets are extremely different. If markets correct, those with higher hedging will manage very well, but if not, it’s an opportunity lost. Funds have, in the past, got their hedging calls wrong.

The table below shows the range of hedging and return metrics for the category.

Therefore, balanced advantage funds can serve to deliver strong returns but are far from low risk. They are also highly unpredictable in their allocations and no two funds are the same. It is very important to know how aggressive a fund is before adding it to your portfolio. Also remember that high equity exposure does not translate into high returns; in these cases, returns depend on the stock-selection and debt strategy the fund follows.

How to use: Balanced advantage funds are also sought after for their ability to shift allocations based on markets and their equity taxation. These funds need a minimum holding period of at least 2 years.

• These funds are not debt substitutes. They are by far more volatile than even equity savings funds. So, they can only be partial replacements for debt allocation and it would be prudent to make such substitutions only in long-term portfolios and only with those funds that use derivatives well to hedge equity risk. In short-term portfolios, equity savings funds are a better debt substitute given the limited risk that you can take.
• These funds are best used to introduce higher-returning component in your portfolio without going for pure equity funds (which are high risk). They are especially useful in shorter-term portfolios of 3-4 years where it is hard to allocate too much to pure equity. For long-term portfolios, they help diversification. They are also good fits if you have fresh surplus to invest but are wary of deploying more into equity when markets seem expensive.
• These funds cannot be the only category to hold, to manage the asset allocation in your portfolio, to help you manage market risks. Funds can have a very different take on markets compared to your own, views can go wrong or be taken with a different timeframe than you assume. For a balanced advantage fund to materially impact your portfolio allocation, your exposure to the funds has to be very high – which can compromise risk, returns and diversification.

Multi-asset allocation funds

Where they invest: These funds need to invest in at least 3 asset classes, at a minimum of 10% each. Usually, funds have gold as the third asset class (after equity and debt) though a few do hold other commodities such as silver. Funds can also use derivatives in equity to hedge portfolios if they so wish; it is not a given. Each fund has its own methodology to determine allocation to each asset class.

How they return: Note that this is a relatively new category, introduced by SEBI in 2018, and most funds are even newer. Therefore, how funds change their allocations across market cycles and the impact on returns is not fully understood at this time. However, with the history available, funds are a motley set in returns and risk. Some have excelled in containing downsides and delivering returns by deftly managing the asset class exposure while others have faltered. Performance depends on both the allocation to each asset class and the investment strategy followed within it.

The table below summarizes average returns and loss probabilities of equity savings funds over different timeframes. Figures are average for the category.

Predictability in allocations: Multi asset allocation funds are extremely unpredictable in their allocation to equity, debt, commodity, cash or derivatives. Some funds try to maintain 65% in equity to meet the taxation criteria while others can be very dynamic. Allocations will be dependent on the fund’s view of the relative risk-return position between each asset class. In July 24 portfolios, for example, the equity allocation ranges from less than 50% to all the way up to 75%. There is a fund that has hedged its entire equity allocation. There is no way to gauge what a fund may do.

How to use: Multi-asset allocation funds need a holding period of at least 3-5 years. Note that taxation depends on the underlying asset allocation.

• These funds are good portfolio diversifiers. They are good additions to long-term portfolios to add moderate-risk equity options instead of pure equity funds. Funds with a conservative approach can also be useful for those with small portfolios where holding separate debt and equity funds is hard. Like balanced advantage funds, these funds are also good options for those with investible surplus who want to stay away from pure equity during heady markets.
• These funds are not debt substitutes in any way, partially or fully. Unlike equity savings and balanced advantage funds, multi-asset funds do not hedge equity risk. That makes them much more volatile and puts them closer to equity in downside risks than debt.
• These funds cannot be used to determine asset allocation in your portfolio, to help you manage market risks. One, funds can have a different take on markets compared to your own. Two, those that aim to maintain 65% equity (for tax purposes) will not serve your idea of altering asset allocations based on markets. Three, even where funds do dynamically shift, the allocation impact on your portfolio can be different from what you need. Views can also go wrong or take time to play out. This apart, for a multi asset fund to materially impact your portfolio allocation, your exposure to the funds has to be very high which can compromise risk, returns and diversification.

Aggressive hybrid funds

Where they invest: These are straightforward funds; the original hybrid fund before all the equity savings and balanced advantages came along to confuse the category. These simply invest up to 75% in equity and hold the remaining in debt. In equity, funds can go across market capitalisations and many frequently use mid-and-smallcaps to bump up returns. In debt, funds generally stick to quality papers and don’t take credit risk. They may, however, aim to play duration if the rate cycle offers such opportunity.

How they return: These funds are better during market corrections than pure equity funds, but they are among the riskiest within the hybrid space as they are primarily equity with no hedging. However, returns do match up and these funds have in the past even matched large-cap funds in returns.

The table below summarizes average returns and loss probabilities of equity savings funds over different timeframes. Figures are average for the category.

Predictability in allocations: Hybrid aggressive funds are fairly standard in their allocations as they simply maintain a 75-25 (or thereabouts) allocation. While they can get aggressive in their marketcap allocations, barring a couple, funds rarely go too heavily into mid-and-smallcap stocks; the average allocation in the past 1 year has been about 25%. This makes it easier to gauge how hybrid aggressive funds can impact equity and debt allocations in your portfolio.

How to use: Hybrid aggressive funds need a timeframe of at least 3 years. they are treated as pure equity funds for tax purposes. These funds are good portfolio diversifiers and are very useful to add moderate-risk equity exposure to any portfolio for any investor. For beginner investors or those with small portfolios, they are good ways to get introduced to equity funds.

Balanced hybrid funds

Balanced hybrid funds can hold 40-60% of their portfolio in equity with the remaining in debt. Funds cannot use derivatives to hedge portfolios. These rules place these funds at a tax disadvantage to most other hybrid categories. In terms of returns or risk, balanced hybrid funds have no edge either – aggressive hybrid funds can return much more, and equity savings/ balanced advantage are better at containing downsides.

AMCs can also have either an aggressive hybrid fund or a balanced hybrid fund in their lineup. Given that many AMCs already have the former and the lack of any distinct advantage, there were no balanced hybrid funds at all.

It is only after the debt taxation change that two AMCs have now launched balanced hybrid funds; the first is only just completing 1 year. With no returns to go by, it is not possible to see how these funds perform on upsides or volatility.

Even so, we do not see any benefit in going for these funds. For low-risk equity options, equity savings and balanced advantage are well-suited and have better tax efficiency. For higher returns with moderate risk, aggressive hybrid and multi-asset allocation will work well. Combining these funds along with pure equity and debt funds will serve the purpose of balancing risk, returns and taxation.

Use the MF Screener to know the latest asset allocation, hedged and unhedged equity in hybrid funds. Prime Funds will give you recommendations in low-risk hybrid funds (useful for debt substitution) and moderate-risk hybrid funds that take into account strategy, downside containment, returns and more.

Hybrid funds have become quite complex in the way their portfolios are structured and their impact on your own portfolio risk and returns. Therefore, it is important to first understand these aspects before adding them to your portfolio. Avoid making decisions based only on taxes and remember that pure equity and pure debt funds can also do a good job in delivering returns without a high tax burden.