Hybrid funds are interesting options – they neither work entirely like equity, nor entirely like debt. And when you add derivatives into the mix, the lines get even more blurred. Conservative hybrid funds have long been used by investors who are looking for debt-plus returns by adding a dash of equity without taking on too much equity risk. But the advent of equity savings and balanced advantage funds has chipped away at the higher-return-for-low-risk bastion that conservative hybrid funds had.
We’ve also often answered your queries on conservative hybrid funds to go for, and why we don’t have a recommendation from that category in Prime Funds or in our portfolios.
Comparing the conservative hybrid category with the equity savings and balanced advantage will explain which one works better. So, we looked at performance across these three categories from the following perspectives:
- The returns across timeframes and their consistency
- The level of volatility in returns
- The extent of risk, both in terms of downsides and in terms of credit
In the above angles, the comparison is between conservative hybrid funds with each of the other two categories. We haven’t gone too far back in analysing returns as both the equity savings and balanced advantage categories have a mixed history – a clear distinction between the two came about only in 2018.
Let’s cut to the chase from the start. On pure returns, conservative funds deliver lower on an average compared to equity savings and balanced advantage. 1-year returns rolled over the past 5 years show average returns for the conservative category at 8.4% against the 10.03% for equity savings and 13.02% for balanced advantage. Rolling 3-year returns over the past 6 years shows the same result of outperformance of the equity savings and balanced advantage categories over the conservative hybrid.
From the data above, you could quickly conclude that conservative hybrid is not up to par compared to the other two categories. However, an important factor to consider is how consistently equity savings and balanced advantage deliver higher returns than conservative hybrid.
Owing to the higher equity allocations in balanced advantage, the category comfortably outperformed the conservative hybrid. Based on 1-year returns rolled over the past 4-year period, it outdid conservative funds 73% of the time. Over a longer 3-year returns rolled over the past 6-year period, outperformance was 91%.
But because equity savings funds have much lower equity allocations, their returns have been much closer to conservative hybrids – the average returns data above already shows that. Therefore, it is not a surprise to see that the conservative hybrid category beat the equity savings 51% of the time on a rolling 1-year returns over the past 3 years.
Does this mean it doesn’t matter which of the two between equity savings and conservative hybrid you go for? Not quite. Here’s why:
- Equity savings funds slid in the sharp sell-off in February-April 2020. Close to a third of the time that conservative hybrids delivered superior was centered around this period. The market dip saw equity savings funds also up their equity exposure to take advantage of cheaper markets – fund asset-allocation models would also have prompted higher equity. Returns for equity savings funds moved back up by end 2020. Therefore, it would need steep and swift corrections for returns of equity savings funds to take a severe blow. In other words, it takes such corrections for conservative hybrid to convincingly beat equity savings.
- The extent of outperformance also matters. In the periods that conservative hybrid beat equity savings, the average margin of outperformance was about 1.8 percentage points. On the other hand, when equity savings did well, they did so much better – the average outperformance margin was 4 percentage points. For example, the highest average 1-year return in equity savings funds was a good 35%, against the 23% average for conservative hybrid.
- Drilling down into fund-wise performance also shows that fund selection in conservative hybrid plays a key role in determining return consistency. Of the funds in the category, just about a third beat the equity savings more than 60% of the time.
- Given that 1 year is not the ideal holding period, extending into 2- and 3-year periods shows better consistency. For 3-year returns rolled over the past 3 years, the equity savings category beat the conservative hybrid 74% of the time. The higher equity allocation accords superior returns over the longer term.
With that overall picture, the next factor that assumes importance is taxation. For a less than 3-year period, conservative hybrids are taxed at slab rates. Equity savings and balanced advantage funds are taxed at 15% for a less than 1 year holding and at 10% beyond that, with the first Rs 1 lakh in gains being tax-exempt.
Therefore, for those with a less-than-3 year timeframe and in the lowest 5% tax bracket would stand better chances of superior returns with conservative hybrid funds rather than equity savings funds. For example, using the same 3-year rolling returns, the post-tax returns at a 5% tax for conservative hybrid still beat equity savings half of the time. Consistency still remains low against balanced advantage as the returns are much higher there.
Please note that taxation of conservative hybrid funds has recently undergone a change. There will be no distinction between long term and short-term holding period for these funds. The gain from these funds will be added to your total income and taxed at your income tax slab rate. This new law is applicable for investments made after April 1, 2023. You can read about this in greater detail in our article ‘Tax changes in mutual funds – how to manage your investments now’.
Volatility and risks
As is clear from the points above, equity savings tends to suffer more on the downside – as does balanced advantage – compared to conservative hybrids. Conservative hybrid funds, on an average, have about 20% to equity. Equity savings funds on an average have had about 30-40% in unhedged equity (i.e., the portion of equity holding that is not covered by derivatives) over the past two years. Balanced advantage funds are even higher at about 45-50% in unhedged equity exposure.
Clearly, volatility is higher in both equity savings and balanced advantage. More, both categories have seen more instances of losses over a 1-year period than conservative hybrid. Not just that, return declines are steeper in the short term. Conservative hybrid funds also have better downside containment that the other two categories at times when the main market Nifty 50 declines.
However, this is market volatility and reduces on holding for at least 1.5-2 years. This is among the reasons why we avoid recommending such funds for shorter timeframes.
With conservative hybrid funds, their predominant debt nature indicates other risks that may be masked and which can lend uncertainty to performance.
- One, credit risk. Superior returns can come by a fund taking credit calls; the earlier years when downgrades swept across fund holdings saw some hybrid conservative funds take a severe hit. Credit risks remain high in funds such as ICICI Pru Regular Savings, Aditya Birla SL Regular Savings, HDFC Hybrid Debt, and Nippon India Hybrid Bond. Allocation to papers rated below AA+ has been between 15-50% on an average over the past year. Therefore, if fund decides to take credit calls where it sees opportunities, it changes its risk profile and minimum needed timeframe compared to when you may have invested in it
- Two, duration risk. With no definition on the maturity profile a fund can take, fund average maturities in the category run the gamut. For instance, consider the January 2022 fund portfolios. The lowest average maturity in the category is 0.41 years and the highest is 8.8 years. Some funds also drastically shift maturities even over short-term periods.
A longer maturity profile indicates both higher volatility and higher risk, and therefore require a longer holding period; missteps on duration calls can suppress returns as well. Unless the fund defines its duration strategy in its mandate, there is no certainty over the nature of call the fund will take.
Both these risks detract from the promise that conservative hybrid funds may otherwise hold on the return front. therefore, if you do invest in conservative hybrid funds (as we mentioned above, those in the 5% tax bracket and a 1-3 year holding period can consider these funds), check for credit risk, besides keeping an eye from time to time on credit exposure to ensure that it stays in line.
While equity savings and balanced advantage funds may have some credit risks, this is marginal and has been reducing as well. HDFC Equity Savings is the only outlier here with a 13% average allocation to papers rated below AA+. Credit calls, where they exist in the category, are more or less limited to AA/AA- rated papers and not below that.
This is also not including the higher expense ratios that conservative hybrid funds carry compared to either of the other two.
In short, if you are using hybrids as a mere diversifier for a 2-3 year portfolio, both from a tax and return perspective, equity savings works. Balanced advantage can be more volatile, but still usable if you’re keen on the higher returns. For those in the lower tax bracket and especially valuing less volatility, conservative hybrid can work provided you are careful enough to pick one without high credit or duration risk. If all this is too much work, here’s a simpler solution – hold pure debt funds for debt allocation and equity for equity allocation 😊
Regular income from SWPs
Conservative funds were earlier popular under the name of Monthly Income Plans. These funds – then - were meant to be regular dividend payers and were often used to set up monthly cash flows. The developments over the years have seen that MIP tag fade out.
But the conservative hybrid category remains a preferred option for those seeking to set up a systematic withdrawal. Our recommendation in SWPs is to use only liquid funds for immediate withdrawal and for the first few months of cash flow requirement, and other debt categories such as ultra short, low duration, and short duration for the rest.
For those looking outside pure debt funds, the conservative hybrid, equity savings and balanced advantage all offer alternatives. Of the three:
- Owing to its lower volatility, the conservative hybrid category allows for earlier withdrawal. This is important because return dips, combined with steady withdrawals, can eat into your capital. A quick check using the top fund from each category – Canara Robeco Conservative Hybrid, Kotak Equity Savings and ICICI Pru Balanced Advantage – shows that a hit on capital from immediate withdrawal is minimized in the conservative hybrid fund.
- For those in the lowest 5% bracket, conservative hybrid funds make good investment options to run SWPs in the short term.
- For higher tax brackets, the heavier tax hit does make equity savings more attractive – but the risk here is always that your investment bears the brunt of an equity correction. While returns do bounce back over time, as both markets pick up and the fund’s allocation adapts to market scenarios, the underperformance could see you eating away at your capital in the short term. For instance, let’s say you invested in Kotak Equity Savings in Jan 2019 and started an SWP immediately. Your investment value dips right from the following month, moves back up a few months later, and drops a good 11% by March 2020. If this risk is something you are willing to take because taxation is your primary bugbear, then equity savings may be an option.
- Balanced advantage funds have the highest risk of your investment value dropping below your original investment. Avoid starting an SWP immediately after or even within a few months of your investment. Swapping Kotak Equity Savings in the same example above with ICICI Pru Balanced Advantage, your investment value would have been 20% below cost in March 2020. Over the longer term, however, the superior return makes it the better choice to hold an SWP corpus if you’re looking to diversify away from debt.