Mutual Funds: What are hybrid funds and how are they different from equity and debt funds?

Investments can generally be categorised into three types based on risk: equity (high-risk), debt (low-risk), and hybrid investments. Investment advisors typically recommend creating an investment plan that aligns with your financial goals, risk tolerance, and investment horizon. 

Since everyone has unique needs and aspirations, it's challenging to classify an investor strictly as either a high-risk or low-risk taker. This is where hybrid mutual funds come into play, offering a versatile solution that blends elements of both equity and debt to meet diverse investment preferences.

What are hybrid funds?

Hybrid funds are mutual funds that invest in a mix of equity (stocks) and debt (bonds) securities. The primary goal of these funds is to offer investors a balanced portfolio with the potential for growth and income. The allocation between equity and debt can vary based on the fund's investment strategy.

Equity component: Provides potential for high returns and capital appreciation.

Debt component: Offers stability and income through regular interest payments.

Types of hybrid funds

Hybrid funds can be broadly categorised into several types based on their asset allocation:

Multi-asset allocation fund: Invests in at least three asset classes with a minimum of 10% in each. Offers broad exposure and flexible asset allocation based on fund manager decisions.

Aggressive hybrid fund: Allocates 65-80% in equities and 20-35% in debt. Aims for high returns with reduced risk through moderate debt allocation, benefiting from equity tax treatment.

Dynamic asset allocation fund or balanced advantage fund: Shifts between 100% debt and 100% equity based on financial models. Ideal for investors seeking automatic adjustment of asset allocation.

Conservative hybrid fund: Invests 10-25% in equities and 75-90% in debt. Focuses on stable income from debt with a small equity component for added growth.

Equity savings fund: Balances risk by investing 65-100% in equities, with minimum 10% in debt and for hedging to be specified in the SID derivatives.

Arbitrage fund: Exploits price differences between cash and futures markets. Invests 65-100% in equities and 0-35% in debt. Provides stable returns with equity tax benefits and minimal volatility.

Key differences between hybrid funds, equity funds, and debt funds

Understanding the distinctions between hybrid, equity, and debt funds can help you choose the right investment option:

Asset allocation

Hybrid funds: Invest in both equity and debt securities. The allocation varies based on the fund’s objective, providing a balance of risk and return.

Equity funds: Primarily invest in stocks, focusing on capital growth. These funds are higher risk but offer the potential for significant returns.

Debt funds: Invest in bonds and other fixed-income securities. They aim to provide steady income with lower risk compared to equity funds.

Risk and return

Hybrid funds: Offer a balanced approach with moderate risk. The mix of equity and debt helps in managing volatility and providing steady returns.

Equity funds: Higher risk due to market fluctuations but also the potential for higher returns. Suitable for investors with a longer investment horizon.

Debt funds: Lower risk and more stable returns compared to equity funds. Ideal for conservative investors seeking regular income.

Investment horizon

Hybrid funds: Suitable for investors with a medium to long-term investment horizon who seek both growth and stability.

Equity funds: Best for investors with a long-term horizon who can withstand market volatility and are focused on capital appreciation.

Debt funds: Ideal for short to medium-term investors who prioritise income stability and capital preservation.

Tax implications

Hybrid funds: Taxed based on the equity and debt components. Long-term capital gains (LTCG) on equity investments are taxed at 12.5% (above ₹1.25 lakh), this is applicable in aggressive hybrid fund, dynamic asset allocation or balanced advantage fund, aggressive and equity savings hybrid funds.

While debt investments are taxed at 12.5% without indexation, this is applicable in Conservative hybrid funds only.

Equity funds: Long-term capital gains exceeding ₹1.25 lakh are taxed at 12.5% where holding period is more than 12 months. Short-term gains are taxed at 20%.

Debt funds: Long-term capital gains are taxed at 12.5% without indexation where holding period is more than 24 months, while short-term gains are taxed as per the investor’s income tax slab.

Suitability

Hybrid funds: Suitable for investors seeking a balance between risk and return. They are ideal for those who want exposure to both equity and debt but prefer a managed approach.

Equity funds: Best for investors with a higher risk tolerance who are looking for significant growth and can endure market ups and downs.

Debt funds: Ideal for risk-averse investors seeking regular income and capital preservation.

Conclusion

Hybrid funds blend equity growth with debt stability, providing a diversified investment within a single fund. They offer a balanced approach for those seeking both growth and stability.

In contrast, equity funds focus on stocks, offering higher risk and potential returns, while debt funds emphasise stability and regular income with lower risk. Understanding these differences helps tailor investments to your financial goals and risk tolerance.

Consider your objectives, risk appetite, and investment horizon before investing. Hybrid funds are ideal for a balanced strategy but evaluate them in the context of your overall portfolio. Consult a financial advisor to make decisions suited to your specific needs.

Rohit Gyanchandani is Managing Director at Nandi Nivesh Private Limited