How to choose the right hybrid fund based on your investment horizon –

Posted: November 24, 2020 at 7:56 am

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Bhavana Acharya

At a time when stock markets have charged ahead and worry about volatility is in the air, most conservative or moderate risk investors are told to turn to hybrid funds. The equity-debt blend helps keep returns afloat across equity and debt market cycles, goes the understanding.

Within hybrid funds, though, there are six categories. Each is distinct from the other in its performance potential and risk level. All hybrid funds dont automatically suit all investors or all time-frames. Heres how the hybrid fund categories compare on key performance metrics.

The hybrid categories considered here are as follows: arbitrage, equity savings, conservative hybrid, balanced advantage, and aggressive hybrid. Multi-asset allocation funds have been skipped though they are hybrid funds, there are very few funds in this category to identify category trends; these funds also need a much longer timeframe for performance assessment and as it is new category, we do not have such a long track record.

Losses and volatility

Hybrid funds can be used primarily for two reasons:

-to give better returns than debt without going after pure equity. This is mostly for the more aggressive investors who want more mileage from their investments.

-to give some exposure to equity without the attendant risk. This is more for moderate and conservative investors, who dont want to miss better returns but cant take the risk that comes from pure equity.

Either way, whats key here is the risk containment. That can be measured by the occurrences of losses, the depth of such losses, and how volatile returns can be. So, consider the past three years, since it covers different equity market cycles. The table below shows the worst return each category has delivered on an average, for different time-frames within this three-year period.

Based on rolling return for each period from Nov.2017 to Nov 2020

As you can see, arbitrage funds are the best at keeping losses in check. The category that slips the most during corrections is the aggressive hybrid category. Stretching this period farther back to five years also sees hybrid aggressive funds fare similarly; the categorys worst average one-year performance was a 22.6 percent loss.

Now, consider the frequency at which such losses occur. The table below shows the proportion of times each category slipped into losses, on an average, for different time-frames. This time, were going further back to 2015.

Based on rolling return for each period from Nov.2015 to Nov 2020

The sharp sell-off in March-April this year sent many equity savings and balanced advantage funds tumbling. For many equity savings funds, this swift correction accounted for much of the periods where shorter-term returns slipped into losses. This goes to show that even in categories where equity exposure is low, a quick and steep stock market fall can wipe out a chunk of the gains.

Volatility in returns tracks the same trend. Aggressive hybrid funds are by far the most volatile, followed by balanced advantage funds. Conservative hybrid and equity savings funds are similar in terms of volatility while conservative hybrid funds are predominantly debt, bond prices do react to interest rate changes or expectations and there will be volatility to that extent. This apart, where conservative hybrid funds adopt duration to book gains on yield rallies, volatility can see a spike.

Portfolios and risks

So what explains the differences in loss probabilities and volatility within each category? The answer lies in how much each category holds in equity, derivatives, and debt. In their derivative calls, funds primarily take the opposite position in the futures market on the stocks in their portfolio (they also take other mispricing opportunities, all collectively termed as arbitrage).

This serves to negate equity risk; the more a fund takes these derivative calls, the less equity it has thats left open to market movements. Its this open or unhedged equity that influences losses, volatility as well as returns.

Arbitrage funds hedge the entire equity exposure, which makes them the lowest risk hybrid funds. And therefore, they do not show loss instances beyond any one-month period. Aggressive hybrid funds dont hedge at all, except in rare cases. The extent to which they fall is thus the highest among hybrid funds. And given that these funds also dip into mid-cap and small-cap stocks, periods such as 2018 and 2019 saw these funds slide more than some large-cap equity funds.

The table below shows how the unhedged equity has been over the past 12 months, other than arbitrage funds. The same trend will hold for earlier periods as well.

Conservative hybrid funds are the lowest on equity exposure. Given SEBIs rules, these funds cannot go above 25 percent in open equity. On an average, in the past year, these funds have held 21 percent in equity. But on the flip side, with no restrictions on debt, some conservative hybrid funds have significant credit risk. More, their changing debt strategy also lends to uncertainty.

Balanced advantage funds are free to change allocations based on market conditions, unlike equity savings funds which need to define their exposure to equity, debt and derivatives in their mandate. The category, therefore, sports wide differences in their equity, derivative and debt holdings as well as the manner in which these change over the months.

Performance across time-frames

On the other hand, when markets rally or over the long term, funds with a bigger open equity exposure will deliver better. On a rolling three-year return in the past eight-year period, the average return for aggressive hybrid funds was 9 percent. The best return in this period was a good 20.1 percent. Thats far above balanced advantage funds, where the maximum return was 16.2 percent.

However, in categories such as arbitrage or even equity savings, returns will be similar whether long-term or short. Arbitrage funds are very similar to liquid funds in terms of return; they do not gain from equity market movement. Equity savings funds have low equity allocations, which caps how much returns can rise even in prolonged market rallies.

The table below shows the average returns for one-year, two-year and three-year periods for each category based on rolling returns since 2017.

How to know which category to use

Two factors help determine whether hybrid funds will work for you and which one to go for timeframe and risk appetite. Another factor that can play a role is your need for tax efficiency.

For a very short-term horizon of six months to one year, arbitrage funds can be used by those who seek tax efficiency, as an add-on to debt holdings. No other hybrid category fits.

For timeframes of 1-3 years, equity savings funds can similarly be used by those in the higher tax-brackets. These funds offer a better return profile than arbitrage funds. As with arbitrage, use them along with debt funds. High-risk investors can allocate more to these funds, while conservative investors need to keep exposure limited.

You can also use conservative hybrid funds for 2-year holdings and longer, but fund selection needs care. These funds can change debt strategies, take on duration risk, or credit risk. You may inadvertently have a riskier fund than the timeframe calls for. Balanced advantage funds work for a 2-3 year horizon but only by aggressive investors, when used along with pure debt funds.

For a 3-5 year timeframe, balanced advantage funds fit well as they do not fall as much as hybrid aggressive funds do, while being better on returns than equity savings or conservative hybrid funds. Exposure can be decided based on risk level.

Very long-term portfolios can use any category. But note that arbitrage and equity savings funds would be lower-returning than debt funds. Balanced advantage funds can partly replace debt funds for very aggressive investors who do not prefer debt funds. Aggressive hybrid funds can be used for equity exposure, but note that it may be easier to maintain an asset allocation using pure equity and pure debt funds.

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How to choose the right hybrid fund based on your investment horizon -

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November 24th, 2020 at 7:56 am