Modules for Beginners
Debt and Securities
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Let’s begin this chapter by introducing you to Shreya’s dilemma. You see, she was on her way to Mona’s birthday party. Mona was her colleague - an acquaintance with whom Shreya got on nicely. But she didn’t quite know her well enough to get her a personalized gift. In fact, that’s what Shreya’s dilemma was all about. She was not sure of what to give Mona on her birthday.
So, she wandered into the biggest supermarket in her locality, hoping she’d find something that may spark an idea. Aisle after aisle turned out nothing special, and just when a disappointed and anxious Shreya made her way to the exit, she spotted the ideal gift, sitting snugly by the cash counter.
It was a box of assorted chocolates.
“Perfect!” Shreya thought to herself. She quickly paid for the box, had it gift-wrapped, and skipped to Mona’s house, all eager to enjoy the party.
Now, what made the box of assorted chocolates perfect?
Well, for one thing, it had a variety of options.
For another, it worked because though Shreya was not sure what Mona’s tastes were like, she could count on the fact that the birthday girl would like at least one of the chocolates in the box.
So, even if Mona didn’t like any of the other flavors much, she could enjoy whatever she did like. All in all, a pretty good deal, don’t you think?
That’s the thing about assorted packs, or combo packs, as they’re more commonly known. And it’s no wonder that they’re just about everywhere.
At your local grocer’s.
At the gadget store.
At the home furnishing outlet.
Even at your local stationery store.
It just so happens that the investment market has its own version of an assorted box. And we call them hybrid funds.
Here are the details. Let’s look at the hybrid funds definition and meaning first.
What are hybrid funds?
Hybrid funds are mutual funds that invest in many different asset classes. Here’s a glimpse of some of the asset classes that hybrid funds may invest in.
- Debt instruments
- Real estate
Mostly, however, hybrid funds invest predominantly in equity and debt investment options. These funds rely on some primary principles that guide how the investments are made. More specifically, hybrid funds are driven by three core concepts.
- Asset allocation
Correlation is essentially how the many different investment instruments move with respect to one another. Instruments within the same asset class are highly correlated, while those that belong to different asset classes are rarely highly correlated, unless they belong to the same sector.
For instance, it’s more likely that equity stocks will move in similar directions, depending on the overall market movements. However, such movements may not affect debt instruments in the same way.
Say you have Rs. 1,000 and you need to buy some groceries for the week. You’ll perhaps write up a list of vegetables and fruits, and then, you’ll allocate your money among those items on your list. Or something like that, right?
Asset allocation is just what this is. It’s the process of deciding how the investors’ funds are to be distributed among the different asset classes that the hybrid fund chooses to invest in.
Diversification is a natural effect that’s observed in hybrid funds, because the very essence of these funds is that they invest in multiple asset classes. This brings down the overall risk in the portfolio.
How do hybrid funds work?
Let’s take the most common type of hybrid fund to understand how these funds work. Predominantly, equity and debt are the most preferred asset classes. Equity does the job of bringing in the market-linked returns, which can even be inflation-beating in some cases. Sure, the risk is higher, but that’s where the debt component steps in. It lowers the risk of the portfolio and also guarantees the investor stable returns. The returns are often lower than what equity gains, but they’re safer. So, this proves to be a nearly equal trade-off.
Based on the proportion of funds allocated to equity and debt - that is, based on the asset allocation - the overall risk of a hybrid fund may be on the higher or the lower end of the spectrum. That’s what makes hybrid funds perfect for a variety of investor profiles.
Types of hybrid funds
- Equity-oriented hybrid funds
These hybrid funds are also known as aggressive funds, because they invest predominantly in equity. The primary goal of these funds is to increase the possibility of earning high returns over the long term.
- They invest at least 65% (and at most 80%) of the funds in equity
- The remaining 35% (or 20%) of the funds are invested in debt and money market instruments
- The equity investments are made across market caps, industries and sectors like banking, FMCG, finance, IT, healthcare, real estate, automobile, etc.
- Debt-oriented hybrid funds
Also known as conservative funds, these hybrid funds invest primarily in the debt market. The key goal here is capital preservation coupled with income generation.
- Debt-oriented funds invested anywhere between 60% to 90% of their funds in debt instruments like government securities, debentures, bonds, treasury bills, etc.
- The remaining funds are invested in equity, in a bit to improve the overall return.
- Some conservative funds may also invest a small part of the funds in cash and cash equivalents to account for liquidity.
- Balanced funds
Balanced funds, as the name implies, try and balance out the asset allocation between the two main asset classes - debt and equity. They ensure that the risk of capital erosion in the equity market is offset by the capital preservation in the debt market.
- Around 40% to 60% of the funds may be allocated to equity instruments across different sectors and market caps.
- Similarly, around 60% to 40% of the funds may be assigned to debt instruments.
- Monthly Income Plans (MIPs)
You’re perhaps familiar with MIPs by now, since we looked at it earlier, in the chapter about the types of debt funds. Often, they’re classified as debt funds because they invest predominantly in the debt market. But MIPs also have an equity component.
- They invest around 15% to 20% in equity.
- The rest of the funds are invested in debt instruments that offer a fixed income payout.
- In this way, MIPs offer a steady stream of income to investors. The payouts can be made at different frequencies - such as monthly, quarterly, half-yearly, or annually - based on the investor’s choice.
- Multi-asset allocation funds
Multi-asset allocation funds are just what they sound like. They invest in multiple assets, beyond just equity and debt.
- They tend to have a portfolio made of at least 3 different asset classes.
- These funds invest a minimum amount of at least 10% in each asset class.
- They expose the investor to multiple asset classes with just one point of investment.
- Dynamic asset allocation funds
Depending on the market cycle, equity may be the better investment option at some points, while debt may prove to be the better choice at others. Dynamic asset allocation funds are hybrid funds that help you take advantage of market movements.
- The portfolio is diversified and the asset allocation is adjusted based on macroeconomic trends and the overall market conditions.
- So, this fund can, at some points, even be 100% debt or 100% equity.
- Equity savings funds
Equity savings funds are a type of hybrid funds where the asset allocation is done across stocks, debt instruments, and risk-free hedging instruments like derivatives almost equally.
- The derivative component minimizes the directional risk associated with equity.
- These schemes invest around 65% in equity assets and around 35% in debt.
- The derivative component reduces volatility.
- Arbitrage funds
Arbitrage funds rely on the arbitrage trading strategy to generate returns for the investor.
- In these funds, the fund manager buys an asset at a lower price in one market, and sells it at a higher price, for a profit, in another market.
- During market phases where there are no arbitrage opportunities available, these hybrid funds park most of the capital safely, in debt and cash instruments.
Tax implications of hybrid funds
Since hybrid funds have multiple assets in their portfolio, it becomes necessary to classify them according to their nature before discussing the tax implications thereon. For the purposes of taxation, hybrid funds are generally divided into two categories:
- Equity-oriented funds: Where at least 65% of the funds are invested in equity and equity-oriented securities
- Other hybrid funds: Those that do not qualify as equity-oriented funds
Now, let’s look at the taxation for these two categories of funds.
Type of capital gain
Long-term capital gain
Gains when funds have been held for more than one year
Tax-free up to Rs. 1 lakh, and taxed at 10% above Rs. 1 lakh
Short-term capital gain
Gains when funds have been held for less than one year
Taxed at 15%
Type of capital gain
Long-term capital gain
Gains when funds have been held for more than 36 months
Taxed at 20% after indexation and 10% without indexation
Short-term capital gain
Gains when funds have been held for less than 36 months
Taxed as per the applicable income tax slab rate
Should you invest in hybrid funds?
Hybrid funds come in many varieties, so there’s always some kind of hybrid fund that is suitable for every investor. Nevertheless, it helps to look into the most common categories of investors who may benefit from choosing hybrid funds. That way, you’ll know if they are for you, right?
So, here’s when you could typically benefit from hybrid fund investments.
- If you are new to mutual fund investments
- If you’re inching closer to retirement
- If you want to invest in multiple assets with the right asset allocation
- If you wish to inherently diversify your mutual fund investments
This wraps up the chapter on hybrid funds. Now, all that remains is to help you figure out how much you should invest in debt and debt funds. Weren’t you just wondering about that? Well, we’ll help you figure this out in the next chapter.
A quick recap
- Hybrid funds are mutual funds that invest in many different asset classes like debt, equity, gold, real estate, etc.
- Equity-oriented hybrid funds, also known as aggressive funds, invest predominantly in equity.
- Debt-oriented hybrid funds, also known as conservative funds, invest primarily in the debt market.
- Balanced funds, as the name implies, try and balance out the asset allocation between the two main asset classes - debt and equity.
- Monthly Income Plans invest around 15% to 20% in equity. The rest of the funds are invested in debt instruments that offer a fixed income payout
- Multi-asset allocation funds invest in multiple assets, beyond just equity and debt.
- In dynamic asset allocation funds, the portfolio is diversified and the asset allocation is adjusted based on macroeconomic trends and the overall market conditions.
- Equity savings funds are a type of hybrid funds where the asset allocation is done across stocks, debt instruments, and risk-free hedging instruments like derivatives almost equally.
- Arbitrage funds rely on the arbitrage trading strategy to generate returns for the investor.
- Hybrid funds are taxed according to whether they are equity-oriented or not, and according to whether the capital gains are long-term or short-term.