Take hybrid funds route for better risk-adjusted returns

The equity markets are on a tear, not just in India, but across the globe. There were calls of their disconnect from reality while rationale is put up to show that this isn't abnormal. The two extreme arguments have valid points substantiating their claim. Like they say investing has multiple styles and one needs to find their own for success, needn't adhere to any one aspect of this argument. Personally, I feel at these instances, asset allocation becomes a critical key for not just better returns, but for a better investing experience.

Certainly, pockets of markets are still attractive and 'value,' but would the timelines for their gestation meet ours, should be the moot point. So, how should one respond to the current market. Remember, what would've been if one were to pull out of equity a little over a year back when there was huge crash, they would've certainly missed the entire rally. It's very difficult to assess the continuity of the market from here. It could further go, there could be corrections and may be remain directionless - all these are perfect features of stock markets and we need to imbibe in our strategy.

But, if one were to feel discomfort to continue to invest in these markets, one could take a mezzanine route. Hybrid mutual funds or even Dynamic Asset Allocation funds form a good strategy to address this scenario. There's a subtle difference in these especially with aggressive hybrid and dynamic asset funds, which would be dwelled further into the essay. Hybrid automobiles run on usually two or more fuel sources. The traditional petroleum products and the other from a fuel cell charged from to the traction or an alternative batter system as source of power. This way the overall cost of transport is reduced while also condensing the pollution. Similarly, the asset composition of a hybrid fund is usually two or more types which help in not only generating returns, but also reduce volatility. In a conventional hybrid fund, the investment is diversified to debt and equity, while the proportion of the allocation makes them either conservative or aggressive.

In the debt-oriented hybrid funds, the proportion of allocation to fixed-income instruments like government securities, bonds, debentures, treasury, etc., stands always at the least of 75 per cent in these instruments while the remaining is reserved for equity-oriented instruments making them less aggressive or conservative in nature. The capital gains treatment on these funds is at par with that of debt funds. The small equity exposure in these funds could enhance returns marginally higher than those of the pure debt funds. These were the erstwhile Monthly Income Plans (MIP) which were all sub-categorized by SEBI (Securities Exchange Board of India) as conservative hybrid funds.

The fund, however, flourishes during presence of such arbitrage opportunities. This is especially true when the markets remain volatile and have higher activity. In other periods, they could invest in debt instruments and cash. In principle, these funds have a risk profile similar to that of the debt schemes but the tax treatment is that of equity funds. So, investors looking for moderate returns could settle for these in tough times with better post-tax returns.

Then there are as a category Balanced Advantage funds and Dynamic Asset Allocation funds. Though they could be part of the hybrid structure, the fund philosophy and operation are divergent from the plain hybrid funds we discussed above. While these funds constitute two or more asset classes, there's no restriction on their exposure to the various assets as described in the other funds mentioned above. These funds could turn being conservative to aggressive depending upon the market conditions. Though, the equity allocation is tweaked i.e., increased or decreased, arbitrage is used to ensure they have the equity and related instruments hovering about 65 per cent and above. This allows the equity taxation for the investors while reducing the risk in the investment.

These funds could play as a counter to the prevailing market situation and also act as a contrarian approach. An exposure to such funds could act as a good counterbalance in an equity-biased portfolio or where equity exposure is higher. It's hence, imperative for investors to spread their investments across these fund categories than just exploring the pure equity or debt funds in their portfolio to enjoy better risk adjusted returns.

(The author is a co-founder of Wealocity, a wealth management firm and could be reached at [email protected])