Last Updated on Feb 10, 2022 by Ayushi Mishra

Mutual funds are broadly categorized into three segments- equity funds (high risk), debt funds (low risk), and hybrid funds. Investors can opt for either based on their financial goals, risk profile, and availability of funds. Investors who are willing to take some risk for the sake of returns (and find that balance) but do not want to be at either end of the threshold of risk-returns, may consider investing in hybrid funds.

This article covers:

What are Hybrid funds?

Hybrid funds are a type of mutual fund that is typically a combination of equity and debt investments. In essence, a hybrid fund invests into two or more asset classes and diversifies across a mix of bonds, stocks, commodities and other securities. These funds are great for investors who want a carefully crafted portfolio having exposure to both debt and equity. 

With hybrid funds, investors can avoid the risk of concentration in your portfolio and achieve a calculated blend of both debt and equity that offer higher returns alongside some level of capital protection than what a single debt or equity fund offers. The percentage mix of debt to equity in hybrid funds depends on the investor’s choice, risk profile, and financial goal. These funds give you the best of both worlds and help you achieve your financial goal with the right amount of risk. A combination of both these can also offset the negative repercussions of a crisis in the debt or equity market.

How do hybrid mutual funds work?

Also known as asset allocation funds, hybrid funds allow investors to invest in multiple asset classes via a single fund. They have a varying level of risk associated with them, which helps investors determine what is the right mix for them. The fund manager of a hybrid fund will allocate the investor’s money in predetermined ratios in equity and debt instruments.

The equity portion of your investment will give you gains in the long run while the debt portion of your investment will give you regular income via its interest-generating mechanism.

Types of hybrid mutual funds

The types of hybrid funds are demarcated on the basis of the quantum of exposure the fund has to the chosen underlying assets. The most popular types of hybrid funds are:

1. Equity-oriented hybrid funds

These funds invest at least 65% of the money in equity instruments and the rest in the debt and money market.

2. Debt-oriented hybrid funds

These funds invest at least 60% of their assets in debt instruments like bonds, debentures, and government securities.

3. Balanced hybrid funds

This fund balances the equity and debt portion of your investment and invests a minimum of 40% and a maximum of 60% in either of the asset classes. A benefit of investing in a balanced fund is that it uses equity and debt components to leverage current market scenarios to generate wealth in the long term.

4. Arbitrage funds

These funds buy stocks at a lower price in the spot market and sell them at a higher price in another market. Majority of the investment in these funds is made in equity instruments. When arbitrage opportunities are not available, these funds invest in debt securities and cash markets, making the investment relatively sound and safe.

5. Multi-asset allocation fund

The best way to invest is not to put all your eggs in one basket. Multi-asset allocation funds do exactly this. Invest in multiple asset classes like gold, equity, debt, and others.

Benefits of hybrid mutual funds

Hybrid mutual funds offer dual benefits of debt and equity to the investors and help diversify the portfolio. The diversification may further increase when the fund manager allocates portfolio in the equity portions across smallcap, midcap, and largecap segments. Hybrid funds are one of the most convenient forms of investment and help lower the risk involved when seeking equity exposure.

With hybrid funds, investors with different risk tolerances can choose how they want to invest their money. There is a range of hybrid funds one can choose from. They offer higher returns than debt funds and have shown to perform at par with equity funds as well. 

The expense ratio of a hybrid fund is also lower than isolated equity funds. Not to mention, hybrid funds allow investment via the SIP method which is the most suitable method for the salaried class.

Nevertheless, the biggest advantage is the ability of hybrid mutual funds to balance risk and return. They are great for meeting short-term financial goals and investing for the long term as well.

Who should invest in a hybrid fund?

Hybrid funds are a fantastic choice for new investors who don’t want to take a lot of risk at the beginning of their investment paths. First-time investors get adequate exposure to equity funds with minimal risk since they are much safer than equity funds.

Less conservative investors can also opt for hybrid funds to take just the right amount of risk and also have a cushion against market fluctuations. Budding investors can start their investment journey with hybrid funds to avoid high-risk investment instruments that they might not have knowledge about.

What to consider before investing in hybrid funds?

1. Risk-return assessment

Based on the type of hybrid fund you opt for, understand the risk associated with it. An equity-oriented hybrid fund will be riskier than a balanced fund or a debt-oriented fund. Remember, no investment in the equity market is risk-free. This is why it is better to exercise caution and choose the proportion of equity and debt funds in a disciplined manner.

2. Investment horizon

Understand your goals and then pick a hybrid fund that matches them. For instance, you may want to invest in balanced funds with a dividend option for your retirement.

3. Cost

Like all other funds, hybrid funds also charge a fee to manage your portfolio. One must lookout for a low expense ratio when opting for a hybrid fund.

4. Investment strategy

While hybrid funds allow investment in multiple asset classes, there must be a sound strategy to choose these. Fund managers must ensure a careful selection of a combination of assets without the investors’ influence.

Taxation of hybrid funds

Equity-oriented funds with over 65% allocation in equity will be taxed like equity funds. They will be liable to long-term capital gains tax of 10% if you hold them for over one year. Equity-oriented funds held for less than one year are liable to short-term capital gains tax of 15%.

Debt-oriented hybrid funds are taxed like debt funds. The capital gains are added to the investor’s income and taxed as per their income bracket. Hybrid funds with debt components held for more than three years are liable to a long-term capital gains tax at 20% with indexation and 10% without indexation.

Disclaimer: Consult your tax advisor before making any transaction.

Hybrid mutual funds offer a dynamic portfolio to investors looking to benefit from both equity and debt markets. Using the principles of asset allocation and diversification, an investor can generate wealth and avoid market volatility at the same time. One can also start investing in hybrid funds by opening an account and purchasing the fund like any other mutual fund.

Kushal Dudheria