The Mutual Fund Show: Your Guide To Investing In Hybrid Funds

There are aggressive hybrid funds. And then there are conservative hybrid funds. Depending on one’s needs and goals, investors can opt for one of them.

That’s according to Raghav Iyengar, chief business officer of Axis AMC; and Amol Joshi, founder of Planrupee Investment Services; both of whom participated in BloombergQuint’s weekly series, The Mutual Fund Show. The fund managers suggested that aggressive hybrid funds—which have 65% allocation to equities and the remainder to debt—are suitable for those with moderate to aggressive risk appetite.

Conservative hybrid funds have allocation to debt that can range from 75% to 90%. Joshi said returns in this category have tapered since the credit crisis of last year.

“Earlier, 70%-90% of the debt component used to have a 8%-9% yield to maturity, and thus returns were higher,” he said. “Now, many of the funds have shifted from aggressive credit stance to a AAA, AA kind of a credit stance, and hence the returns have come off.”

Before investing in conservative hybrid funds, Iyengar urged investors to ascertain the scheme fits with their risk profile as they aren't immune to volatility.

Joshi recommended ICICI Prudential Equity and Debt Fund in the aggressive category and SBI Debt Hybrid Fund among conservative schemes. “Both these schemes have done very well," he said.

Watch the full interaction here

Edited excerpts of the conversation

Raghav, can we start with the aggressive hybrid, if you will, if you can start with that and can you put this into perspective, because not everybody will remember all the aspects of the show. So in a nutshell, the ones that we've spoken about and then how does aggressive hybrid differ from the ones that you've spoken about thus far? What kind of investors should go in for this?

Raghav Iyengar: If you remember some time back, we started this lovely show and this lovely conversation around hybrid funs. I think just to put a context of hybrid, what is hybrid I mean, most of us talk about hybrid from a fuel category you have hybrid cars, which are the most fashionable thing but hybrid funds are nothing but a mix of various investments. In the current mutual fund theme, there are six categories of hybrid funds. So, hybrid fund is like a plain arbitrage fund, which does a bit of equity and arbitrage together. There is of course the balanced advantage category or the dynamic equity category, which is the second part which allows the fund manager huge amount of flexibility, you can go from almost zero to 100%. Obviously, you have the aggressive and the conservative hybrid which we're going to talk about today and we also have another beautiful category called the equity savings category. All these essentially what they do is, they have different levels of equity depending on the scheme that you're investing in. So today of course, we're going to talk about the last two products, which are very big. I mean, in fact the mutual fund industry started up if you remember almost about 50-60 years back with UTI being the first there and the two biggest categories when I started my career in 1998 used to be the aggressive hybrid or at that time it was called the balanced category and now, the regulators have changed the name to make it more reflective of the asset class.

Of course we have the conservative hybrid fund which is nothing but a debt hybrid fund where the proportion of debt is much higher than equity. As the name pertains, I think the category is very large as you can see it's almost about Rs 5 lakh crore, the aggressive hybrid category is almost about 35% of that and about Rs 1,45,000 crore. It is a category which is, in some sense used to be the first stop for any first time investor because it essentially as the name points out, it's reports about 65-80% of the allocation of the fund about 100 rupees into equity, and the balance 20 to 35 rupees goes into fixed income or debt instruments. Why do we need this mix? I think typically when you find that when it gives you a better or a slightly more steadier investment experience, so when you take two asset classes which traditionally move in different directions and you can see, there have been points of time if you go back as recently as eight-nine years back you will find that equity gives a very negative return, you will find fixed income also does very well. In some sense the fixed income acts as a cushion and in some sense this if you mix match these, especially debt and equity in the proportion that I talked about, I think overall you would have, I would say interesting a better investment experience because obviously the debt portion tends to cushion any downfall.

Why is it so relevant today? Because obviously the question which everyone keeps asking us and I'm sure it's in your mind also is that I need to invest money but I'm a little worried about returns is this a good time to invest? Or should I put my money in lump sum? Should I put my money in SIP? So these are some of the questions that I keep getting when I keep talking to some of our investors and some of our partners and I think this in some sense, the aggressive equity answers that question because if you're coming in and you are a little worried about politics, I think the auto allocation feature which is that, the fund manager has the ability to move the equity between 65 and 80 depending on his or her perception of where the equity market is, is much better than as a direct investor doing it.

Many of the investors today are what I call DIY do it yourself, sometimes they tend to make decisions based a little bit on emotion. Now everybody's on this bit of an equity euphoria. They have a fear of missing out, we call it FOMO. Everyone wants to jump into equity but there you have to be very smart or you have to have someone in the background holding your hand making sure that you don't get excessive either into fear or into greed, which are the two negative emotions when you're dealing with investment. In some sense the aggressive equity category takes care of that because it allows the fund manager to auto allocate. So, remember that when you're moving from different asset classes within the same scheme, there is no taxation. In that sense it's a more tax efficient scheme for you to do it and for people like me, the lazy investors who don't typically tend to rebalance their portfolio very often I think this is in some sense like a fill-it, shut-it, forget-it. Of course, the difference between this one and let us say the equity savings category, which we spoke about in the previous episode is that yeah, this one has a slightly higher percentage of allocation to equity. If you remember the equity savings fund had a 20 to 50% allocation, whereas in this case, actually it's about 65 to 80. So obviously if you're a little more bullish about markets, and there is likely a better risk appetite that you have and a slightly longer investment horizon, then this set of funds is a good category to put money into.

For what kind of investors does this scheme offer compared to the other hybrid categories? And what has been your experience at the Axis house when it comes to this particular scheme? One in the last 18 months where almost everything has done well but maybe even before that?

Raghav Iyengar: I think that's a great question because as I said, we started with six categories in the hybrid space so this is as the name denotes is the most aggressive part of it. So this one will have a minimum of 65% in equities, almost two thirds of your 100 rupees is in equity. I would put it in the risk ladder if I were to make a ladder of risk, this would be at the highest step but below equity funds. So obviously somebody wants to get into equities but is a little worried about market correction ultimately, you invest money to sleep well, if you're going to be worried about what happens if the market falls 5-10% will, what will I do? I think this is a category for that kind of an investor who is reasonably bullish on the market, who has the time horizon to keep money, who can stomach a bit of maybe short term intermediate loss at the same time doesn't want the rollercoaster ride over traditional equity funds.

So yes, because it's two-thirds almost an equity fund this will have obviously volatility it's not like fixed income which has a reasonably straight line. Obviously, the volatility will be much more. Axis is a recent entrant into this category, we've just launched about four years back I think our experience has been very good. I think obviously the last 12 months have been quite spectacular and this fund has done very well in this category. I think of course, investors have largely benefited in this space. Right now, as I mentioned in the hybrid space, it is very difficult to compare schemes from various fund houses because this is the only category where you can do effectively anything you want in the equity and in the fixed income space. So, I could have a small-cap bias, I could put money to mid-cap. Unlike the other regular equity funds let's say in a large-cap fund you have to put a minimum of 80% in large-cap there is no such caveat over here and then on the fixed income side I could be running a AAA fund or I could be running an AA fund.

So, in Axis as we mentioned, we believe this is meant for slightly lesser aggressive investors as compared to equity. At this point of time, we are largely large-cap focused we obviously have put large parts of our money in established businesses. We also put some money into turnaround stories as you have seen in the last 12-18 months, a lot of industries have gotten re-rated. On the fixed income side were largely very much on the safety zone, a majority of our portfolios are in the AAA space and we are in the moderate duration space were at about three and a half years duration as per our latest factsheet. So broadly for us, this is a good category of money to come in for a first time investor, for someone who's a little worried about current valuations or somebody who does not have a much longer timeframe to put money into.

Amol, can you share your thoughts? What do you feel about the aggressive hybrid category and what clients of yours and what's the nature of your clients? Would you recommend to choose this one over others in that debt side and within that again, are there any hybrid options available?

Amol Joshi: My answer is not going to be completely different compared to Raghav’s. So as I mentioned, this is something first and foremost, since this is an aggressive hybrid fund, we all have to remember that it invests close to 65% into the equity component, and the remaining 35% is in debt. Equity, as we know is probably the most volatile asset class. So again, using the risk matrix or risk appetite ladder, there are broadly three types of investors conservative, moderate and of an aggressive risk profile. So, I would say this aggressive hybrid category, or the erstwhile balance fund category it's suitable for somebody who is between the moderate to aggressive risk profile investor, but more importantly than that there are a couple of other factors as well. This category has consistently offered investors, this category’s distant cousin, currently and probably is more popular than this category, that is the balanced advantage fund. Both of these categories have offered investors a much smoother investment experience. Whenever you speak of mutual fund schemes in relation to what they can do for investors and how can all of us industry participants work toward having investor experience or investor returns let me put it that way as close to scheme returns as possible, the gap between investor returns and scheme returns is the behaviour gap. We know that very well.

I'm also glad you mentioned about 18 months back so what happened 18 months back, as we saw India as well as globally, the stock market crashed by 40% or so. I have seen several investors throwing in the towel right at the bottom and many times we also fall prey to recency bias. So, what is recency bias? It tells you is if the market has been sliding, if the market has been going down, you think and you extrapolate at exactly the same events or exactly with the same trajectory into the future as well. Now, this category of hybrid funds, the categories that we spoke of, essentially because of having 35 to 40% allocation, 35% kind of allocation to debt, the fall is cushioned. If you do a simple mathematical calculation for a 30% kind of a fall, you will fall in the balanced category or in the aggressive hybrid category close to 20%. This is just mathematical and it will vary from scheme to scheme but suffice to say somebody who is between the moderate to aggressive risk taker, somebody who also has an investment horizon of three to five years and somebody who does not want to lose sleep over the equity market’s ups and downs and if you don't like to see your portfolio jumping too much, I think this category is for you.

Let's switch and talk about the other category as well. Because if one identifies themselves not as an aggressive investor but a conservative investor then what must one do? Raghav, what about conservative hybrid funds?

Raghav Iyengar: Lovely category again, it used to be an industry-beta category if you remember a long time back, there used to be this product called monthly income plans, which were nothing but a mixture of higher debt allocations out of your 100 rupees and about 75 to 90 rupees would be in debt and the balance 10-25 would be in equity. Today, again 10-25 brings the investment rationale closer to what it does, I think the regulator has called this conservative hybrid or debt hybrid funds. As the name indicates these funds have a much higher proportion of debt. So, one thing one must understand firstly is that these are debt funds so they are subject to different taxation too. They are effective if you hold them for less than three years and redeem the money before three years you will be subject to short-term capital gains tax which is the tax that you pay on the rest of your income. If you hold for more than three years, you pay a concessional tax of 20%, less indexation. Indexation is nothing but the value of inflation adjusted in the tax rate. Yes, if somebody has again completely converse or reverse as the name points out, we are talking about two very different categories in the same show, we just talked about aggressive hybrid.

This is exactly the reverse conservative hybrid. Here the debt allocation will be anywhere between 75 to 90% equity allocation will be anywhere between 10 to 25%. Again as I said there is no structure on the fund management or the fund manager to buy whatever he can buy whatever stocks or whatever market capitalisation he wants and on the debt side also he can buy whatever type of fixed income security that he wants. He can be in AA, AAA etc. Again, just doing a mathematical comparison and comparing returns sometimes is a bit dangerous because I think my way of judging the efficiency of the fund management team here is how these products actually do when the market tends to fall. Like Amol pointed out again the debt is a beautiful cushion here. So, largely investors see this as a debt plus investment. Obviously, there is equity between 10 and 25%. So, it won't be as stable as a debt fund. It will have its ups and downs but obviously much lower as compared to aggressive equity because the equity allocation will be just about 1/4 of the total portfolio. So yes today it is a great category for retired investors, a great category for anybody who has a shorter time duration and also given the fact that there is now some level of taxation on equity, even if you hold as you know in an equity fund even if you hold for more than a year, you pay that 10%. So actually, if you hold for three years, the difference in tax between an equity fund and a conservative hybrid fund is not that much. It is there but not that much as it used to be in the past when equity was tax free. So it's again a great entry category, especially in today's interest rate scenario where rates are very less. bank deposits or low rates are low, other savings instrument rates are low. I think this is a nice category for people who want to or are able to take that slightly extra volatility, put money and obviously have a slightly longer time period.

You have anything like let's say three years plus kind of money, you have maybe between three and five years you see an immediate need for it but at the same time you are able to and want to take that bit of additional volatility because of equity, I think this is a great product to come in with. This used to be the erstwhile monthly income plans 15-16 years back, they used to be giant categories in those days. The AUMs were supposed to be very large. Today, largely because of the fact that people are uncomfortable of mixing this level of debt and equity today, I think the amount of AUM in this product is very less in the industry. As I said it's possibly the slowest in all the four categories or six categories that we've discussed. Yes, I think the good thing about this category in the entire hybrid space as you can see on the slide, I think amount of investment is largely a retail investment scheme. I think very obviously, as you can make out, there is very less institutional money here because institutions are largely focused on the fixed income space and obviously on the retail side again, since it's a bit of a DIY product people who want to take that slightly additional risk they come here. Advisors like Amol who want to suggest something like a debt plus investment, this is a good place for you to get in to.

What are the pitfalls for this?

Raghav Iyengar: Pitfalls are equity, equity is obviously volatile and obviously you need to also make sure that your credit is matching the fund management’s style of credit. There are many people who just assume that because it's a conservative hybrid fund, the percentage of allocation to AAA will be very high. That's not the case. As I said, the fund manager has the choice to put whatever money that he or she wants in AA or AAA. So, you just need to make sure that your debt part of it, it's all in the public domain is fitting your risk profile and number two obviously just be aware of the fact that this product will have a 10 to 25% equity allocation. So yes, it will be volatile, obviously much less as compared to a plain vanilla equity fund. But yes, there will be a range of volatility.

Amol, one quick thought firstly on the category itself?

Amol Joshi: Conservative hybrid as we discussed on this show earlier, it was a darling of investors earlier, but I have one more reason to add to as to why this scheme has fallen out of favour from the investors’ mind. The reason is, as we have discussed earlier, the scheme has anywhere between 75 to 90% of a debt component. Now we have completely come out of the high interest rate regime in the overall economy. We see that in the PPF rates, we see that in FD rates and of course the mutual fund debt market is not immune to it. So earlier in this category 70 to 80-90% of the debt component used to have an 8% 9% kind of a yield to maturity. Now, since after the credit crisis of the last calendar year, many of the funds have shifted from aggressive credit stance to a AAA, AA kind of a credit stance, as well as, as I mentioned earlier, the interest rate environment has completely changed. So long story short, instead of previous old generation 8 to 9% of YTM till date, YTM has reduced somewhere between around 5 to 6% only. Equity per se is a much less significant component. So I would say that this is one more reason as to why conservative hybrid is no longer finding favour among investors because the overall return generation ability of the schemes has come down.

Now you also mentioned, my thoughts quickly on this scheme. I would say that balance advantage category is a good substitute to conservative hybrid. The simple reason is, balanced advantage although they can move from 0 to 100% equity, but most of them do move between 30 to 80%. As we speak, one of the largest balanced advantage funds a few of them in fact, with markets being at an elevated levels, the equity levels are about 34-35%, let's say 35 to 40% or so. So, this is significantly lesser and it will offer you a large protection if markets were to roll over from this stage. So, I would say conservative while it was a good category earlier, I think balanced advantage is more suitable for investors as it will fulfil their needs in a similar manner.

Can you recommend some funds in both the categories even if people want to go ahead and do an investments?

Amol Joshi: So, sticking into the timeline, I would say that in aggressive hybrid, you can look at something called ICICI Prudential Equity and Debt Fund. We have discussed the product composition so I'll skip it. In conversative equity category, you can look at the SBI Debt Hybrid Fund. Both of these schemes have done very well. Raghav mentioned that his scheme also has had a good time over the last one to two years but my recommendations are, ICICI equity and debt for aggressive hybrid and conservative hybrid, SBI debt hybrid scheme.