Please note: The Government has decided to remove the long-term capital asset benefit for some mutual fund categories. They are:
- All debt mutual funds including target maturity/index debt funds and ETFs
- All gold funds and ETFs
- All international funds
- All conservative hybrid funds in their current form
- All Fund of funds, except those that invest only in equity ETFs
- Any other fund category/scheme with exposure of less than 35% in domestic equity.
There will be no distinction between long term and short-term holding period for the above categories of 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 in more detail in our article ‘Tax changes in mutual funds: How to manage your investments now‘.
This is the third part in our series on how to use Prime Funds when building your portfolio. The classifications and fund mix we use in Prime Funds are designed based on your investment purpose, rather than the fund’s SEBI category.
Therefore, understanding how we approach Prime Funds and how each category can be used in a portfolio will make it easier for you to get the most of our recommendations. In this Part 3, we will cover hybrid funds. Part 1 explained equity funds and Part 2 explained debt funds.
(Quick note: if portfolio building is not up your alley, you can always use our readymade portfolios – Prime Portfolios – to make your investments)
Hybrid categories in Prime Funds
Hybrid funds don’t really suffer from the overlapping drawbacks we pointed out in our explanation on Prime Funds’ equity and debt recommendations. However, we still use our basic logic when it comes to portfolio building – given an investment purpose, which fund will fit that need?
Hybrid funds are generally used as a route to participate in equity, get debt-plus returns, but without the pure equity risk. Now, there are some hybrid categories we ignore in Prime Funds.
One, conservative hybrid – we find that categories such as equity savings and the lower-risk balanced advantage funds manage better returns as a whole along with better tax-efficiency.
Two, multi-asset allocation funds – these funds have limited history and a wide range of allocations. There’s also a lack of control over the allocations, and taxation depends on your exit timing. Moreover, the dynamic management of equity allocations and volatility containment is addressed by balanced advantage funds – meaning that we do not think these funds help a portfolio in any way.
Therefore, the categories we consider are arbitrage, equity savings, balanced advantage and aggressive hybrid. Based on the level of equity exposure involved and fund volatility, we classify hybrid funds into two categories.
Hybrid equity – Low risk
These are funds that use derivatives to hedge either the entire equity exposure or the majority of it. Using derivative and arbitrage opportunities allow a fund to neutralize the equity risk they take.
Usually, funds in this Prime Funds set would be from the arbitrage, equity savings or balanced advantage categories. Arbitrage funds hedge their entire equity exposure, and their returns are very similar to liquid funds. Equity savings funds hedge anywhere between 20-40% of their portfolio.
Where balanced advantage funds are concerned, we have picked only those that are very conservatively managed (i.e., unhedged equity does not swing wildly, is usually lower, and volatility is also low) for this category. However, returns are usually above debt funds.
On the taxation aspect, all these funds are treated like equity funds. This makes their post-tax returns superior to debt funds for short-term timeframes, especially for those in the higher tax brackets.
How to use
These funds are not must-haves in a portfolio and you can ignore them as they meet a very limited range of purposes. Use the following guidelines for this category:
- For a very short-term period: Arbitrage funds can be used to hold money temporarily or for very short-term timeframes of 1 year or lower, like you would with liquid funds. However, since these are not really debt funds, they do have some volatility. It’s best to have at least a few months in the holding timeframe. These funds can be used by those looking principally for tax efficiency and short-term holdings. It is mostly only the tax that sends their returns above liquid funds. For those in lower tax brackets or where tax is not important, skip them. Don’t allocate your entire debt investment in these funds, however attractive they may seem on returns. Use a mix of arbitrage and liquid/very short duration funds.
- For medium time frame: These funds can be used by those looking for debt-plus returns in portfolios of 1.5 to 3 years. Their tax efficiency is the added advantage. However, go by your risk profile when deciding allocation. They are best used by moderate to high-risk investors, who want returns better than debt funds without the equity risk. Know that these funds can fall during stock market corrections. Conservative investors can skip these funds. Avoid using these funds for long-term portfolios, as the cap on equity will mean low returns. The tax edge also diminishes once the 3-year period is crossed. This apart, longer-term debt funds can clock better returns. These funds can be used in post-retirement portfolios or in income-generating portfolios to build a cash flow stream through SWPs. Their low-risk nature along with better returns than very short duration debt funds work well in these cases. Our Capital Savings readymade portfolio is an example of using these hybrid funds along with safe options to build a more tax-efficient, better-returning portfolio.
Arbitrage funds are the lowest risk in this set. The other funds, though belonging to different categories, fare similarly in terms of risk and return. When looking at returns, know that the extent of hedging will have an impact. For instance, when equity is up and a fund’s return is lower compared to others in the set, it will probably be on account of it taking much higher derivative calls. Read the ‘Why this fund’ to know their strategy and suitability.
Hybrid equity – moderate risk
This Prime Funds set houses funds that have some debt allocation along with a significant equity allocation (that is not hedged). These funds hold the ground between high-risk pure equity funds and low risk hybrid funds or pure debt funds. In other words, they allow equity participation, deliver better returns than pure debt funds, but are not as volatile or risky as an equity fund.
Funds in this set come from the hybrid aggressive category and the balanced advantage categories. In the latter category, we have picked funds that adopt a more aggressive approach in the extent to which they leave their equity unhedged.
How to use
These funds are a wildcard that can be used in a variety of ways, across risk profiles. Generally speaking, the hybrid aggressive funds would return better than balanced advantage, but would also be more volatile. All funds will need at least a 3-year holding period. You can use the following guidelines:
- For conservative and moderate investors, these funds are great ways to gain better returns without compromising on risk. For example, equity can be added even in timeframes of 3-5 years. If you do not want to hold pure equity funds, these Hybrid Equity – Moderate Risk funds can be an option. Even in longer timeframes, if you do not want to up the equity allocation, you can substitute it with these funds to earn better-than-debt returns.
- For high-risk investors, too, these funds can be used to up the equity allocation. For example, in medium-term timeframes where equity would generally be lower at about 50-65%, you can use these funds to increase equity exposure without going overboard on risk. The balanced advantage funds in this set can be used to partially (not fully) substitute debt allocation for longer timeframes as well.
- For post-retirement portfolios, equity participation can help improve overall returns and reduce the risk of earning less than inflation. Better returns can also help a portfolio stretch out over a longer period. These Hybrid equity – moderate risk funds can help achieve the risk-return balance that retirees may seek.
In this Hybrid equity – moderate risk set, our fund selection is based on their returns, nature of equity holding, and volatility. For instance, we haven’t gone for aggressive hybrid funds that take on hefty midcap/smallcap allocations; we have observed that such allocations make these funds riskier than even large-cap equity funds. Aggressive hybrid funds will be higher-return, higher-risk than the balanced advantage funds. Therefore, read the ‘Why this fund’ to know the fund’s type, strategy and suitability.