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Are hybrid funds meant for you? - Outside View by PersonalFN
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Are hybrid funds meant for you?
Nov 22, 2012

We all invest in equity oriented funds to earn a risk premium. To simply put, to earn over the risk-free rate of return or yield a rate higher than provided by a bank fixed deposits (FDs). Likewise while we invest in debt funds too, our objective is same - to earn a higher rate of return than the post-tax returns offered by bank FDs. The factor influencing our preference is the appetite for risk. Many of you may be aware that investing in equities is riskier than investing in debt, and thus holding that rationale we expect a higher return on our investment in equity. But remember, all equity oriented funds may necessarily deliver superior returns and thus it is imperative to select only wining mutual funds for your portfolio. Also it is noteworthy that while many construe debt funds to be risk-free and assume they always generate positive returns; the fact is within them too, you got to be careful with your selection. You got to emphasize how the funds have performed in various market cycles. Both equity and debt go through various phases of the markets and thus an intense study of them is imperative. As investors in equity oriented fund, you would like to be protected from downside risk during bear phases and earn superlative returns in bull phases. Likewise as an investor in debt funds you would like to play the interest rate cycle well, thereby aiming to generate higher returns all throughout, than offered by your bank FDs. Amongst the various mutual fund categories, hybrid funds is one category which can combine the benefit equity and debt, and relieve you from the worry of tactical asset allocation, while you like to benefit from various market cycles.

Hybrid Funds

Hybrid funds invest in both, equity and debt in a predetermined proportion and usually either of them dominate the overall portfolio due to a strict allocation followed by them. At present for one to select depending upon your risk appetite and investment objective, we have mainly two categories within them, they are:

  • Equity oriented hybrid funds (commonly known as Balanced Funds)
  • Debt oriented Hybrid Funds (which majorly include Monthly Income Plans)

Equity oriented hybrid funds, tilt a larger portion of their asset towards equities as an asset class, while the rest being invested into debt. Balanced funds are popular in this category of hybrid funds who generally invest about 65% of their assets in equities (with some being mandated to elevate their exposure upto even 75%-80%) and the rest in debt and cash. The final call on asset mix is taken by the fund manager after a careful assessment of outlook for debt and equity. The benefit that balanced funds bring with them is they generate equity comparable returns at lower risk. But it is important to note that since 2/3rd of the portfolio is in equities, they are always exposed to risk. Some balanced funds try to reduce risk exposure by holding a large cap biased equity portfolio. Furthermore, they do not take very aggressive calls on a particular stock or a sector. This is also a differentiating factor between a balanced fund and rest of the equity oriented funds. Notably there are a few balanced funds which aggressively invest in equities, take high midcap exposure, take bold sector calls, but try to compensate this by keeping overall equity exposure near the lower range of the band and hold a quality papers in their debt portfolio. Since they invest in debt instruments as well, apart from exposing you to risk involved in equity investing, they (balanced funds) also expose one to risks such as default risk, liquidity risk, interest rate risk and reinvestment risk.

Contrary to the asset allocation followed by equity oriented hybrid funds, the debt oriented hybrid funds usually cap their exposure in equity at 25%-30%, and invest the rest in debt instruments of varied maturity profile and quality of papers. In India, debt oriented hybrid funds are mainly comprised of Monthly Income Plans (MIPs). Though not assured, MIPs pay dividends at regular intervals and hence attract many investors who want to generate regular income. Since the debt component is higher, risk involved is much lower than that in the balanced funds. Debt oriented hybrid funds aim to provide higher tax-adjusted returns compared to tax-adjusted returns earned on fixed deposits.

Recently, in the hybrid fund category some mutual fund houses have launched funds with gold as well as in their asset allocation along with equity and debt, since the precious yellow metal has acted as an effective alternative diversifier and safeguarded investors' portfolio thus far. In fact, mutual fund houses have also reckoned that the spectacular returns yielded by gold over last few years have rejuvenated investor's interest in gold. Following a tactical allocation, some mutual fund houses have also launched financial planning funds, attempting to cater to investor various financial objectives (such as retirement, children's education planning, etc.); but let us apprise you that they may not solely help in achieve your financial goals, as customisation in financial planning is paramount.

How Hybrid Funds have Fared?
Category Average Returns 6 Months (%) 1 Year (%) 3 Years (%) 5 Years (%) 7 Years (%) 10 Years (%) Std Dev (%) Sharpe Ratio
Debt Oriented Hybrid Funds 6.2 10.5 6.5 6.5 7.9 8.7 0.94 0.06
Balanced Funds 12.3 15.7 6.4 2.5 11.3 18.5 3.81 0.04
Crisil MIP Blended Index 6.1 10.7 6.5 6.1 7.5 8.2 0.89 0.03
Crisil MIP Blended Index 6.1 10.7 6.5 6.1 7.5 8.2 0.89 0.03
BSE SENSEX 13.4 11.8 2.5 -1.5 11.2 19.6 5.25 -0.02
(NAV as on November 19, 2012. Standard deviation measures
the risk and Sharpe ratio measures the risk adjusted returns and both are calculated over 3 years' time period assuming the risk free rate of returns as 6.37% p.a.)
Note: 1. Returns upto a 1 year time frame are expressed in absolute basis and o compounded annualised for a 1 year period
2. Average returns are the simple average of returns generated by all hybrid funds during respective timeframes.
(Source: ACE MF, PersonalFN Research)

As far as performance of hybrid funds is concerned, balanced funds and debt oriented hybrid funds have delivered a satisfactory performance over long term. The table given below suggests that, balanced funds have yielded returns competent to those earned by BSE Sensex across timeframes; while debt oriented hybrid funds have been successful in generating decent returns.

The table above also brings forth one more aspect which often gets ignored even by the savvy investors. If you observe, returns generated by the debt oriented hybrid funds have been higher than those generated by Balanced Funds and the BSE Sensex over last 5 years. This highlights that merely selection of an asset class doesn't warrant you high or low returns as returns largely depend on the market cycle sailed by the fund for respective asset classes. One may have witnesses that in last 5 years equities have not moved anywhere on absolute basis, and as a result returns of balanced funds have been very low and BSE Sensex, in fact, has yielded negative returns. Now observe a time horizon little longer than 5 years, say 7 and 10 years (see table above); balanced funds have outperformed debt oriented hybrid funds by far. This highlights the fact that over the long-term with detrimental events fading out, equity as an asset class generally tends to deliver better returns, although in the short-term may be susceptible to risk events.

Note: Returns expressed above are in absolute % terms.
YTD refer to Year-To-Date as is calculated from March 30, 2012 until November 19, 2012)
(Source: ACE MF, PersonalFN Research)

The graph above underscores that, all those years in which the equity markets (as measured by the performance of BSE Sensex) have done well; balanced funds have followed them (though have rarely outperformed.). Similarly, years in which markets have fallen, balanced funds have fallen too but the fall has been much lower. On the other hand, debt oriented hybrid funds have given positive returns year after year in last 10 years. But it is noteworthy that only in 4 out of last 10 years they have managed to generate double digit returns.

Performance across Market Cycles- Debt Oriented Hybrid Funds
  Debt market Cycle Equity Market Cycle Average Returns (%)
26/Oct/04 To 30/Mar/07 Bear Phase Bull Phase 9.6
11/Jun/08 To 20/Oct/08 Bear Phase Bear Phase -3.6
20/Oct/08 To 04/Mar/09 Bull Phase Bear Phase 3.5
04/Mar/09 To 17/Apr/12 Bear Phase Bull phase (upto 05/Nov/2010)
a corrective phase thereafter
17/Apr/12 To 16/Nov/12 Bull Phase Corrective Phase 5.2
(NAV as on November 19, 2012)
Note: 1. Returns for a period less than a year are expressed in absolute terms and compounded annualised if above 1 year.
2. Average returns are the simple average of returns generated by all the debt oriented hybrid funds during respective time frames.)
(Source: ACE MF, PersonalFN Research)

A study of performance cross market cycles reveals how debt oriented hybrid funds have performed in respective phases of the market. It not only considers debt market cycles but also the equity ones (since they invest in equities too) - and there's an interesting finding in it. Like balanced funds, debt oriented funds may also generate negative returns when equity and debt are in a bear market. If any of the markets turns positive; their performance improves. Bull phase in both asset classes maximises the return potential of debt oriented hybrid funds. So, if you expect them to always give you double digit returns then you may be disappointed sometimes. Having said that, if you want to safeguard yourself in a falling interest rate scenario debt oriented hybrid funds may be of help as they are free to invest in debt papers across maturities, whereby if a duration focus is adopted by the fund manager, it can help you yield good returns.

Performance across Market Cycles- Balanced Funds
  Equity Market Cycle Debt market Cycle Average Returns (%)
01/Aug/05 To 09/Jan/08 Bull Phase Bear Phase upto (30/Mar/07);
a flat market thereafter
09/Jan/08 To 09/Mar/09 Bear Phase Bear Phase Between (11/Jun/08 To 20/Oct/08);
a bull market thereafter
09/Mar/09 To 05/Nov/10 Bull Phase Flat market 59.7
05/Nov/10 To 16/Nov/12 Corrective Phase Bear Phase upto 17/Apr/2012;
a bull phase thereafter
(NAV as on November 19, 2012.
Note: Returns are in %; absolute if below 1 year and compounded annualised if above 1 year.)
(Average returns are the simple average of returns generated by all the balanced funds during respective timeframes.)
(Source: ACE MF, PersonalFN Research)

Now have a look at the performance of balanced funds across market cycles. A similar observation could be made out here. Being equity oriented funds their performance largely depends on direction of equity markets. For example the exuberant bull phase of the Indian equity markets prior to the emergence of the U.S. sub-prime mortgage crisis, was supportive for balanced funds. But during the bear of the Indian equity market caused by the aftermath of U.S. sub-prime mortgage crisis which also initiated rising interest rate scenario thereafter, they performed terribly. Only in the immediate ensuing bull phase after the U.S. sub-prime mortgage crisis, balanced funds enabled wealth creation for investors. So, it would be incorrect to expect that balanced funds would do well at all times. However, if you hold onto them for the long-term they could deliver luring returns, as the portfolio is inclined towards equity.


Hybrid funds, whether debt oriented or equity oriented, are meant to provide stability to your portfolio, and can be used for tactical asset allocation. The equity oriented can be considered by one, whose objective is capital appreciation and to achieve the same is willing to take relatively high risk. The debt oriented ones can be good option for those whose objective is to generate income by having a greater portion of their hard earned money being allocated towards debt and money market instruments (which may be across maturities and quality of debt papers), and a smaller portion in equity and equity related securities, which can enable to add the zing and accelerate on performance. Having said that it is vital to note that, hybrid funds can never eliminate the risk associated with equity or debt investing. They merely provide you diversification and tactical allocation vide a single fund. They can therefore be a good starting point for investors who do not have any prior experience in mutual fund investing. This is not to say that savvy investors shouldn't invest in hybrid funds. For them hybrid fund can be an intermediate option between pure income funds and aggressive equity diversified funds.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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