Should you consider investing in hybrid funds for your goal-based portfolios? In this article, we discuss two factors that are often cited as advantages of investing in such funds. We urge you to consider the following arguments before you decide on investing in such funds.
Asset allocation
A hybrid fund is one that invests in both equity and bonds. So, such funds ought to help investors with their asset allocation decision. This refers to how you allocate your annual savings between equity and bond investments.
Suppose you are unsure of the proportion of equity and bond investments to have in your portfolio. By investing in a hybrid fund, you could outsource your asset allocation decision to the manager of the fund, so the argument goes.
The issue is that each goal you pursue requires different asset allocation. For instance, the asset allocation for your child’s education portfolio must be different from your retirement portfolio. Hybrid funds cannot consider your individual goal requirement as it is a collective investment vehicle.
Now, hybrid funds range from equity-oriented funds that may have above 65% in equity to debt-oriented funds that are predominantly invested in bonds. Therefore, you ought to decide on the proportion of equity and bonds you want in your portfolio to select an appropriate hybrid fund. But if you can figure that out, you would have arrived at your asset allocation requirement! Then, you could just as well consider investing separately in equity funds and bonds.
Tax efficiency
But hybrid funds offer tax efficiency, the argument goes. Based on current tax laws, a hybrid fund that holds 65% or more in equity is considered as an equity fund. So, if you redeem your units in such hybrid funds after a holding period of more than 12 months, you have to pay long-term capital gains tax of 10%. If a hybrid fund holds less than 65% in equity, you have to pay 20% capital gains tax with indexation if you sell your units after a holding period of more than 36 months.
Now, suppose you invest 70% in equity funds and 30% in bond funds separately, you have to pay 10% capital gains tax on your equity investment and 20% on your long-term bond investments. However, if you invest in a hybrid fund with the same asset allocation, you will pay only 10% on your total investment.
The above argument is valid if you want to invest in bond funds to meet your bond allocation. Or, if you are willing to assume market risk on your bond investments just to save taxes. Should you?
Conclusion
You will pay higher taxes on your bond investments if you invest in bank fixed deposits instead of investing in bond funds or in hybrid funds. But higher taxes are a trade-off for stable returns. Your fixed deposits and recurring deposits will provide a steady stream of income returns compounded through the time horizon for your life goal. Whereas your bond funds or bond portion of your hybrid funds are marked-to-market through net asset value. You, therefore, expose your bond investments to price fluctuations (and perhaps capital loss) in an attempt to earn higher return.
It is preferable to have a goal-based portfolio that earns interest income from bond investments and capital appreciation from equity investments.
Finally, diversification through equity and bonds can never be argued as a reason for investing in hybrid funds; for, the question is, how to invest in equity and bonds, and not whether to invest in these asset classes.
The above discussion is not meant to discourage you from investing in hybrid funds. Rather, the objective is to urge you to consider these factors before investing in such funds.
(The author offers training programmes for individuals to manage their personal investments)
