What are the opportunities, challenges and considerations for hybrid funds?

What is a hybrid fund?

A hybrid fund is a class of mutual funds that involves investing in more than one asset class. Most hybrid funds invest in a mix of stocks and bonds, though some also include other assets such as gold and real estate.

Hybrid funds aim to diversify the portfolio – and therefore minimise the investor’s risk – by balancing investments across different asset classes. This may result in better returns than debt funds, while being much less risky than equity funds.

The allocation of debt and equity is generally decided according to how much the investor is willing to risk, as well as their financial goals and the general market conditions.

There are various types of hybrid funds which vary in their goals and structure, but all hybrid funds have certain shared characteristics:

Liquidity: All hybrid funds are open funds that allow investors to redeem or add capital at specified intervals. This is especially attractive to investors in an uncertain economic climate.

Diversity: Because hybrid funds are inherently diverse, they offer exposure to a variety of asset types, such as:

• Publicly listed equities
• Private equity
• Real estate
• Infrastructure
• Distressed debt
• Private debt/credit and more

Flexibility: Various aspects of a hybrid fund, such as risk exposure and liquidity, can be adjusted to meet investor needs.

What are the different types of hybrid funds?

Conservative hybrid fund

Conservative hybrid funds are open-ended hybrid funds that invest between 75% and 90% of assets in debt, such as Sovereign, State Government and Public Sector Undertaking, and between 10% and 25% in equity and equity related instruments.

As up to 25% of the fund can be allocated to equity, this type of fund may provide marginally higher returns than debt funds. However, conservative hybrid funds are also less risky than equity funds and are less volatile than an aggressive hybrid fund, so are well suited for risk-averse investors.

Aggressive hybrid fund

As suggested by their name, aggressive hybrid funds invest predominantly in equity and equity related instruments. Between 65% to 85% of total assets is invested in equity, with 25% to 35% invested in debt.

The higher allocation to equity means that aggressive hybrid funds have the potential to generate better returns than conservative funds. However, they are also much riskier.

Balanced Fund

Balanced funds mix equity and debt, with 40% to 60% of assets invested in equity and another 40% to 60% in debt. A balanced fund is typically more equity-oriented than a conservative hybrid fund, but less so than an aggressive fund.

Balanced funds have a healthy capital appreciation, with overall low risk.

Dynamic asset allocation fund

Sometimes referred to as a Balanced Advantage Fund, a dynamic asset allocation fund dynamically invests in both equity and debt based on current market conditions. Fund managers determine exposure to different asset classes based on market conditions, with the potential for up to 100% allocation in equity or debt.

This type of hybrid fund is suited to investors looking for better risk adjusted returns irrespective of market conditions.

Multi Asset Allocation Fund

A multi asset allocation fund invests a minimum of 10% in at least three asset classes. These funds typically increase or decrease allocation to different assets depending on current market conditions.

In addition to equity and debt, multi asset allocation funds include asset classes such as gold or real estate investment trusts. This diversification of the fund also diversifies the investor’s risk.

Arbitrage Fund

Arbitrage funds exploit the price difference between two markets, usually the cash and derivatives markets. The fund manager will purchase stocks in the cask market and then simultaneously sell in the futures market, which means that gains or losses are locked in immediately. This reduces the volatility of equity and allows for more steady returns.

Asset allocation is primarily towards equity, with debt investment at no more than 35%.

Equity savings fund

An equity savings fund invests a minimum of 65% of assets in equity and arbitrage, and a minimum of 10% in debt. It aims to generate returns by investing in arbitrage opportunities with exposure to equity, and can be beneficial for long term wealth generation.

Benefits of hybrid funds

Diversification and flexibility

Hybrid funds diversify risk by combining both equity and debt, among other assets. Investing in a variety of assets minimises risk exposure in any single asset class, as fluctuations in one market can be balanced by returns in another.

This diversity of investments also allows for significant flexibility. Fund managers are able to avoid the rigid structuring rules of traditional hedge funds, and tailor the fund to specific investment goals and time limits.

Balance between risks and returns

The ability to strike the perfect balance between risk and return is one of the biggest advantages of hybrid funds. They allow investors to experiment with making high-return equity investments, while also offering stability through the less risky debt investments.

Arbitrage funds in particular can further lower the risks associated with equity.

Low volatility

Leading on from the last point, hybrid funds also allow for lower volatility in an unstable market. Traditional equity funds are always subject to market volatility, so investing in hybrid funds as an alternative is a good way to lower exposure to this volatility while still making good returns.

Things to consider before investing in hybrid funds

Risk factor

Although hybrid funds carry lower risks than pure equity funds, they are still associated with a certain degree of risk due to the equity allocation. Hybrid funds that invest primarily in equity – such as aggressive funds – generally pose a greater risk, so greater investment in debt securities can help to lower and balance the risk.

It’s always important to consider the investor’s risk profile when deciding how much to allocate to equity investments.

Financial Goals

As with any investment, it’s always important to consider financial goals before investing in a fund. This will allow investors to determine their risk tolerance and desired returns, making it easier to select a fund that is well-suited to their goals.

It’s always advisable for investors to share goals with their fund manager to ensure the correct asset allocation.