Hybrid mutual funds: A better option to leverage asset allocation

In 2023 stock equity markets showed strong performance, but valuation issues have blinked into the year 2024. SEBI warned about frothiness in midcap and small-cap stocks in February causing a correction. The current Lok Sabha elections have added to the volatility of the markets that will continue until the announcement of results.

The current turn of events might prompt Foreign Investment Institutions (FIIs) to move their assets to China even though India's stock prices appreciably surpass those of China (as evidenced by MSCI China (USD) Index PE multiple of 12.65 in comparison to MSCI India (USD) Index PE multiple of 25.94 as of April 30, 2024).

Mirroring some volatility, there has been a downward trend of 10-year G-Sec yields since around April/May 2023, signalling a peak in the bond market. As of April 30, 2024, gold prices have rallied by 18% throughout the last year on account of economic instability alongside increased inflationary tendencies which make it a preferred asylum asset. Lower interest rates also boost gold's attractiveness compared to government bonds.

In such an uncertain environment, effective asset allocation is essential for stabilising investment portfolios. By diversifying across equities, bonds, and commodities, investors can manage risks better and achieve more stable returns despite market volatility. Why prefer Asset Allocation?

Investing can be more of an ups and downs, but asset allocation helps to streamline. Different asset classes, like equities and gold & silver, often perform differently in various market conditions. For example, when equities underperform, gold tends to do well, and vice versa. The counter-cyclical relationships shown below, along with the low correlation both equities and gold have with fixed income, can provide a more stable investment experience. Balancing these assets mitigates risks and keeps investments steady.

Source: Advisorkhoj Research

Moreover, asset allocation keeps you away from behavioural biases like greed and fear, which often lead to irrational decisions during market highs and lows. By maintaining a disciplined investment strategy aligned with your financial goals and risk tolerance, you can avoid the pitfalls of emotional investing. When equities are rallying, investing in debt can balance your portfolio, and when equities are down, shifting towards them can be beneficial.

To leverage asset allocation you can think of Hybrid Mutual Funds.

What is a Hybrid Mutual Fund?

Hybrid funds are mutual fund schemes that invest in multiple asset classes like equity, fixed income, and gold. They cater to various investment needs and risk appetites through different types such as aggressive hybrid funds, balanced hybrid funds, dynamic asset allocation funds, equity savings funds, multi-asset allocation funds, conservative hybrid funds, and arbitrage funds.

Aggressive hybrid funds invest predominantly in equity (65-80%) with a smaller allocation to debt (20-35%), making them more aggressive. Balanced hybrid funds split assets equally between equity and debt. Dynamic asset allocation funds adjust their equity and debt allocations dynamically. Equity savings funds hedge equity using derivatives while maintaining at least 65% in equity. Multi-asset allocation funds invest in three or more asset classes.

Conservative hybrid funds focus mainly on debt (75-90%) with a smaller equity allocation. Arbitrage funds hedge equity exposure using arbitrage strategies, ensuring at least 65% equity allocation.

Pros of Investing in Hybrid Mutual Funds

Hybrid mutual funds offer balanced exposure to both equity and debt instruments, mitigating risk through diversification. The equity portion can generate higher long-term returns, while the debt portion adds stability and reduces portfolio volatility, making these funds an attractive choice for investors.

Hybrid funds also benefit from periodic portfolio rebalancing. Fund managers adjust asset allocation to keep it aligned with the fund's target mix, managing risk and aiming for better risk-adjusted returns over the long term.

Hybrid funds are ideal for first-time or inexperienced investors because they offer lower volatility than pure equity funds, providing a more stable and manageable investment experience. This stability helps new investors gain confidence and experience without facing extreme market fluctuations.

Hybrid funds with over 65% equity enjoy tax benefits similar to equity funds. Those with 35%-65% equity can use indexation for capital gains if held for 36+ months. These tax advantages enhance returns, making hybrid funds attractive for tax efficiency.

Investors in hybrid mutual funds benefit from professional fund managers' expertise in strategically allocating assets to align with investment objectives. Professional management ensures portfolios are actively monitored and adjusted to optimise returns while managing risk in changing market conditions.

Cons of Investing in Hybrid Mutual Funds

Hybrid funds provide lower volatility but may miss out on the full upside of equity markets due to their debt exposure, resulting in potentially lower returns during strong market rallies.

Hybrid funds have higher expense ratios than pure debt funds due to their investments in both equity and debt. These costs can reduce investor returns, so it's crucial to consider expense ratios when evaluating hybrid fund potential.

Taxation of hybrid funds varies based on their asset allocation. Equity-oriented hybrids are taxed like equity funds, while debt-oriented hybrids are taxed like debt funds. This impacts investor returns and should be considered when making investment decisions.

Hybrid funds, due to their debt component, offer stability but limit growth potential compared to pure equity funds, making them less suitable for aggressive investors seeking substantial returns.

Hybrid funds need a long-term view because they invest in various asset classes that operate on different market cycles. To fully benefit from their strategy and achieve significant returns, investors should ideally have a horizon of 3 to 5 years. Short-term investors may not experience the full advantages of hybrid fund investments.

In uncertain markets, hybrid mutual funds offer stable returns through diversification and professional management. However, they may not fully capture equity market gains and have higher costs to consider.