Best Hybrid Funds: A Guide to Understand & Select

Benefits of Best Hybrid Funds

Hybrid Funds are those Mutual Funds that enjoy the flexibility to invest in both equities as well as debt securities simultaneously. As such, the mutual fund portfolio enjoys the potential of higher returns during the long term with its equity component and may also resist the high volatility through the debt portion. Moreover, the benefits of mutual funds include having a variety of schemes under the broad category of hybrid funds itself, to suit the investors have different risk profiles. On one side conservative investors may select hybrid funds with higher debt component. While the investors having an aggressive risk profile and higher risk appetite may go for hybrid funds with a higher equity portfolio.

Diversification

A Hybrid fund offers investors the benefit of diversification because it combines both equity and debt. When the stock market goes down, the debt component in these types of mutual funds ensures stability. So these funds can withstand shocks during a bear phase. Generally, debt and equity are inversely proportionate, they move in opposite directions. So by investing in a Hybrid fund helps you hedge your bets. One thing you must remember is that such Balanced Mutual Funds do not do as well when the market is on a bull run. Another point to note is that when share prices rise, fund managers will have to sell stocks of the hybrid mutual funds to maintain the required equity-debt ratio.

Balance risk and return

One of the biggest advantages of a hybrid fund is that it allows you to balance risk and return. The equity portion will earn higher returns, and the debt part will earn steady returns at a lower risk. You can also choose the mix of equity and debt as per your needs. For example, an aggressive Balanced Fund will invest, say, over 75% in equities and the balance in debt. A conservative fund may invest less than 50% in equity.

Systematic investment plan (SIP)

Another benefit of a hybrid fund is that they let you invest via SIP mode. Best SIP lets you invest depending on how much you can save. Is there any benefit of investing small sums over a period of time? Some feel that it doesn’t matter whether you make a lump sum investment or in installments because you are investing mainly in debt. But it does matter. Especially if the hybrid funds have a higher component of equity. Because there is the risk of entering the stock market when prices are high. In hybrid funds that have a higher component of equity, it’s better to invest via the SIP route since you enjoy the benefit of rupee cost averaging.

Less volatility

Equity funds are subject to the fluctuations of the market. In a volatile market, investors could panic and opt for redemptions. The debt component brings in a kind of stability to hybrid mutual funds, and fund managers can handle redemptions better, ensuring stable returns to investors.

Higher returns

Under certain conditions, hybrid funds have outperformed equity funds. Returns from hybrid funds over the past few years have been more than large-cap mutual funds. This is particularly true in a volatile market.

Lower expenses

As most balanced funds have a fixed proportion to be invested into stocks and bonds, and fund managers tend to place their bets on large-cap stocks, there is very little necessity for active portfolio management. Therefore the expense ratios will be on the lower side for hybrid funds.

Suited for beginners

Hybrid funds are especially suited for first-time investors. They get a balanced exposure to equity.

Disadvantages of Hybrid Mutual Funds

Difficult to compare

One problem with hybrid funds that it is difficult to compare their returns. In the equity funds, for example, you can compare the performance of your fund to their stock market index like the Sensex, or specific indices like large-cap, mid-cap, and small-cap. We can’t do this with a hybrid fund. The only comparison that we can make is with hybrid mutual funds falling in the same category.

Risks

The conception that hybrid funds are risk-free, is not exactly true. There are two sets of risk involved in a balanced or hybrid mutual fund – fluctuations in interest rates and stock prices. If interest rates fall, NAVs will drop. Balanced Mutual Funds are also exposed to stock price risk. When their prices rise, NAVs will fall, according to the proportion of equity in the fund.

Lack of focus

Managing both debt and equity together needs different skill sets. The Fund Managers of hybrid funds may not have enough expertise in both fields. This will result in sub-optimal returns for investors. You need to check the fund manager’s expertise and the track record of the hybrid mutual funds before investing in their fund.

Less option for change

Balanced funds may not be ideal to achieve changing investment goals. For instance, if you want to reduce your exposure to equity, you will not have that choice with a hybrid mutual fund.

How Hybrid Funds are Taxed

Equity-oriented funds, with more than 65% in equities, have the same tax treatment as equity mutual funds. If you hold them for less than 12 months, you need to pay a 15% capital gains tax. Hybrid funds of this type held for more than a year are eligible for long-term capital gains (LTCG) tax at 10%. Hybrid mutual funds with significant investment in fixed income instruments are treated as Debt Mutual Funds. Investors are liable for the LTCG tax of 20% with indexation if they hold them for three years and above. Any short-term gain gets added to your income and is taxed as per the applicable tax slab. Indexation reduces the amount you have to pay as tax, giving a benefit.

Also read Liquid Fund Taxation

Things to Remember

Monitor performance

The best way to follow the performance of hybrid mutual funds is by checking their returns over the past several years. Select a balanced fund that has performed consistently in bull and bear phases.

Risk appetite

Balanced Mutual funds invest in a mix of equity and debt in varying proportions. If you can bear a higher level of risk, you should choose the hybrid funds that have an equity component of 85%. If you prefer moderate risk, the fund with an equity component of 60% should work for you. There are also plans of hybrid mutual funds that cater to low-risk investors, having an equity component of 15-25%.

Expense ratio

The expense ratio is the amount charged by the mutual fund houses to manage your investment. Tru to make sure the expense ratio of the plan you chose is low. Higher expense ratios will reduce your returns.

Time horizon

You have to hold hybrid funds for at least 5-years before you can realize the full benefit of these kinds of mutual funds.