Hybrid funds can be a panacea for market volatility but there's a catch

Investors should, however, be prepared for the fact that lower equity exposure will mean lower returns than from a pure equity fund

With the equity markets turning volatile, fund houses are currently hawking hybrid schemes as an antidote to market volatility. For investors who have a financial advisor, an appropriate mix of equity, debt and gold funds will prove to be a more flexible option. But those who don’t have an advisor, and are not accomplished DIY (do-it-yourself) investors, may opt for hybrid funds.

There may be no respite from volatility in the near future, making these conditions ideal for investing in hybrid funds. “The Nifty has corrected from the peak level of 11,738 in August, but the markets are not yet cheap. Also, the divergence between bond yields and earnings yield has increased the relative attractiveness of debt. Macro risks arising out of high crude oil prices, US interest rates and other potentially volatile events remain. We believe that markets are likely to remain volatile,” says S Naren, executive director and chief investment officer, ICICI Prudential Asset Management Company.

Most retail investors tend to become uncomfortable with significant declines. Most of them evaluate their investments at the scheme, and not the portfolio, level. Suppose an investor holds a pure equity fund that has lost 20 per cent, and a debt fund that has been flat. He is likely to be worried about his equity fund. Now suppose these two funds are combined in a 1:1 ratio. The combined fund’s loss would be 10 per cent, which is likely to worry him less. “It is this behavioural aspect that makes hybrid funds a good choice the markets are falling,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

Source: Ace MF

Certain types of hybrid funds, such as aggressive, equity savings, and arbitrage funds are more tax-efficient. Moreover, when an investor has two funds, he has to bear a tax burden and possibly an exit load every time he sells to rebalance his portfolio.

In a hybrid fund, rebalancing is done by the fund house and means no cost to the investor. Hybrid funds have a few disadvantages, however. Their expense ratio could be high. When an investor wants to pull out money, he may find it difficult to do so because at any given point the equity or debt component may not be doing well. An investor owning two funds can easily sell the asset class that is doing well.

Next, let us turn to various hybrid funds’ sub-categories that you may bet on. Aggressive hybrid funds offer 65-80 per cent equity allocation. “They are suitable for investors who don’t have the risk tolerance for a pure equity portfolio, and are not likely to change their portfolio mix because they have a long horizon,” says Dhawan. However, these funds can be volatile. “Even this category will take a hit, though the extent of decline will be lower than in a pure equity fund," says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor (RIA). Before investing, look at the portfolio closely. “If the equity component has a high exposure to mid- and small-cap stocks, or there is a high credit risk in the debt portion, which could make the fund volatile,” says Raghaw.

Balanced advantage funds follow a quantitative model to decide their equity-debt allocation. “To create wealth, it’s imperative to be counter-cyclical. This fund ensures that equity exposure is reduced when markets are expensive, and vice versa, thereby reducing risk,” says Naren. Investors who want lower volatility may use them.

Multi-asset allocation funds offer an exposure to equity, debt and gold. Investors who want an all-in-one solution may go for them.

Investors who are in the high-tax bracket and have an investment horizon of more than six months but less than three years (which would make them eligible for long-term capital gains on debt funds) may use arbitrage funds, which enjoy equity-like tax treatment.