What are Hybrid Funds: Meaning, Types and Benefits

Hybrid funds are defined as mutual fund schemes that invest in multiple asset classes like debt, equity, derivatives, and gold to create a diversified portfolio. The common type of hybrid scheme is a combination of debt and equity assets, while relatively less common variant may also feature investments in a third asset class like gold or derivatives.

Investors seeking higher returns that pure debt funds and can tolerate slightly higher risk can invest in hybrid mutual funds. The allocation of debt and equity in these funds varies from one type of hybrid fund to another as does the risk and potential returns. So the choice of investment depends on the investors' risk tolerance, financial goals, etc. Hybrid funds can be equity-oriented if the funds are invested more in equity instruments or debt oriented if they allocate a greater portion of their portfolio to debt instruments like bonds, certificate of deposit, etc.

There are two major goals of investing in hybrid funds:

• Capital Appreciation in the Medium to Long Term:

The equity portion of the scheme’s portfolio can help you grow your wealth in the long term.

• Low Volatility in the Short Term:

The debt instruments in the portfolio of a hybrid fund can help in downside protection. This can help reduce the overall volatility of your investment in the short-term.

Securities Exchange Board of India (SEBI) introduced the categorization and rationalization of different types of mutual funds available in India in 2017. The different types of hybrid funds in India as per SEBI guidelines are:

• Aggressive Hybrid Funds:

Hybrid funds that invest 65% to 80% of their assets in equities and the remainder in various debt instruments are called equity-oriented or aggressive hybrid funds. Aggressive hybrid funds can offer high long-term returns but the higher exposure to equities can lead to higher overall volatility of the investment.

• Conservative Hybrid Funds:

Hybrid funds that invest between 75% and 90% in debt instruments while the remainder is invested in equities are termed conservative hybrid funds or debt-oriented hybrid schemes. Investors with relatively low risk appetite can choose to invest in this type of hybrid fund.

• Balanced Hybrid Funds:

These funds allocate equity and debt funds in almost equal proportion. The balanced funds invest a minimum of 40 percent and a maximum of 60 percent of the funds in equity and debt asset classes respectively. These schemes vary their equity and debt allocation in response to changing equity market conditions.

• Multi-Asset Allocation Funds:

This scheme needs to have investments in at least 3 asset classes with a minimum of 10 percent in each of the asset classes. The multi asset allocation scheme allows investors to invest in asset classes beyond equity and debt like gold, real estate, etc.

• Arbitrage Fund:

Arbitrage Funds are a unique class of hybrid funds that operate by buying equities in the cash market and selling in the future market to generate returns from the price difference between the two markets. These schemes invest at least 65% of assets in equities and equity derivatives while the remainder can be invested in other asset classes like debt and money market instruments.

• Equity Savings Schemes:

These funds help in balancing the risk and returns by investing in equity, equity derivatives, and debt. Equity assets (minimum 65%) provide growth to the portfolio, equity derivatives (as per scheme information documents) for hedging and debt instruments (minimum 10%) provide downside protection.

Things to be considered before investing in hybrid funds are:

• Return:

Hybrid funds don't offer guaranteed returns and their returns are affected by market fluctuations similar to pure equity funds and debt scheme. The stability of returns is not guaranteed. Make sure you check long term returns of the hybrid fund over 5 years or more before investing.

• Risk Appetite:

Investors with relatively low to moderate risk tolerance can opt for hybrid funds. However, as these have equity allocation assets, they do carry the risks involved in making equity-oriented investments.

• Finance Goals:

Investors must be clear about their financial goals and how to achieve them. If a particular scheme provides the expected return, then the investor must carry on with the same investment.

• Investment Horizone:

Hybrid funds are considered perfect for investors with medium to long-term investments. Hybrid funds offer better results if you keep investing in them for 3 years or longer, as per financial experts.

A hybrid fund scheme that invests 65% of the total portfolio in equities will attract the same tax rates as equity investments. So, the following mutual fund taxation rules are applicable:

• Long-term Capital Gain Tax(LTCG):

If equity-oriented hybrid fund units are held for more than 1 year, they come under the long-term capital gain at the rate of 10% on annual gains exceeding Rs. 1 lakh in a year.

• Short-term Capital Tax (STCG):

If equity-oriented hybrid fund units are held for less than a year, then the tax rate is 15% of gains.

If a hybrid scheme invests 65% or more in debt instruments, it will be termed a debt-oriented hybrid fund and debt fund taxation rules will be applicable to the investments. Below are the STCG and LTCG rates for such schemes:

• Long-term Capital Gain Tax:

Fund units held for 36 months or longer are taxed at the rate of 20% of gains with indexation benefits.

• Short-term Capital Gain Tax:

Funds held for less than 36 months are taxed as per the income tax slab rate of the investor.

• Access Multiple Assets Classes with a Single Fund

Hybrid funds allow you to invest in multiple asset classes in a single product or fund, and there is no need to invest in different funds

• Active Risk Management

Hybrid mutual funds provide active risk management through asset allocation and portfolio assortment. This means they can control losses better during market lows while during bull runs, the equity portion of the schemes can provide significant capital growth.

• Caters to Various Risk Profiles

They can offer you various levels of risk ranging from investors with conservative to moderate risk appetite. Equity-oriented schemes are there for risk-takers, and debt-oriented schemes are more suitable for risk-averse investors.

• Buying Low and Selling High

The fund manager balances the portfolio by buying the asset class when it is low and selling it when the value increases. This can help provide significant gains for the investors across a wide range of market cycles.

• Automatic Rebalancing

The fund manager can rebalance the portfolio whenever required. This helps to save the time and effort required to track market conditions. Moreover, these portfolio rebalancing purchase and sales are done professionally without any tax implications.