Mutual funds are like departmental stores of financial products, where you generally get the option to buy various and numerous products ranging from pure equity to pure debt, including many products with a mixture of varying proportions of debt and equity. Of all these, aggressive hybrid funds, popularly known as balanced funds, as a category, are an excellent product. Let us understand the various features and suitability of aggressive hybrid funds.
What is the rationale behind the working of aggressive hybrid funds?
Asset allocation is one of the basic fundamental principles of prudent financial planning, which advocates scientific allocation of all your investible funds into various asset classes. These asset classes include equity, debt, gold, and real estate in a broader sense, but in a narrower sense, they include two major asset classes, i.e., debt and equity. So, people who invest in pure equity, either by way of direct equity or in pure equity schemes of mutual funds, have to separately invest in other debt products for proper allocation of their debt portion.
Aggressive hybrid funds cater to both needs with one product, as aggressive hybrid funds always have a minimum of 65% of their investments in equity and the balance in debt, with varying levels depending on the level of the equity market at any given point of time.
In addition to asset allocation, rebalancing of various asset classes periodically is also a second very important and complementary principle to the asset allocation principle. So, the internal proportion of the value of different asset classes in your portfolio does not remain static over the period, and it fluctuates over the investment period due to fluctuations in the market price of the equity investment.
In times of market boom, the value of the equity component goes up, and thus the ratio of allocation to equity also goes up during such time. In order to maintain the pre-specified asset allocation, you need to liquidate/shift some of your equity holdings and use the funds for buying any debt product of your suitability.
Likewise, during the bear phase, the value of equity goes down, and thus the relative percentage of your holding in equity in the value of your overall portfolio also goes down. So, the dual principles of asset allocation and rebalancing help you optimise your overall return by dynamically changing investments from one asset class to another while providing a cushion to your returns.
Since aggressive hybrid funds have both components of debt and equity and cannot have less than 65% of investments in equity at any given point of time, they have to continuously monitor the relative proportion of debt and equity. So, investment in aggressive hybrid funds obviates your need to invest in two different asset classes for asset allocation. It also obviates the need to monitor and periodically rebalance different asset classes in a predetermined proportion.
Taxation aspect of aggressive hybrid funds
Under the income tax laws, any scheme of mutual funds where domestic equity shareholding of the fund is maintained at more than 65% at all times on an average basis is treated as an equity-oriented scheme. So, aggressive hybrid funds, which maintain this 65% of investible funds in equity, are treated as an equity-oriented scheme.
The tax treatment of equity-oriented schemes and debt schemes is different as regards the holding period requirement as well as the tax rate applicable. Profits on units of equity-oriented schemes are treated as long-term capital gains and taxed at 12.50% for profits over ₹1.25 lakhs in a year for all equity products taken together if held for 12 months or more; else, they are treated as short-term capital gains and taxed at a flat rate of 20%.
The profits in debt schemes, where the debt component is more than 65%, are treated as short-term capital gains irrespective of the holding period and taxed at the slab rate. Since the debt component in an aggressive hybrid fund also gets taxed at lower rates, it is a better tax optimisation tool for those who are paying tax at the highest rates.
Minimises the volatility in the returns
The investment in equity as a percentage of overall savings in the country is very negligible. Investments in fixed deposits of banks and companies take the largest pie of the financial investments cake. This is primarily because people generally want the comfort of a fixed return, and equity investments are treated as very volatile.
This volatility of investing in equity is reduced to some extent by investing in aggressive hybrid funds, as part of the investments in debt at all times provides a cushion to the overall return and the fluctuations in the return over the period.
For whom is this product suitable
An aggressive hybrid fund, as an equity investment product, is suitable for first-time investors in equity, as lower volatility in the returns does not frighten them and comforts them. Even if we go by the historical data, the returns generated by aggressive hybrid funds are no worse than those given by large-cap funds in the long run. The returns generated by the large-cap category and aggressive hybrid funds as a category are given hereunder for comparison.
Return comparison of large-cap and aggressive hybrid fund
| Time horizon | Large-cap | Aggressive hybrid fund | Excess return generated by aggressive hybrid funds |
|---|---|---|---|
| 1 year | 0.22 | 3.79 | 3.57 |
| 3 years | 14.41 | 15.34 | 0.93 |
| 5 years | 19.15 | 18.37 | -0.78 |
| 7 years | 13.23 | 13.33 | 0.10 |
| 10 years | 12.58 | 12.53 | -0.05 |
It is also evident from this table that as the period gets longer, the difference in average returns between aggressive hybrid funds and large-cap funds comes down. So, though returns generated by both categories of funds are similar in the long term, as aggressive hybrid funds provide a little more stability to the returns, these are an ideal choice for people who want to invest for the first time. Even this is a better product for people who are of an advanced age and are near retirement, or have already retired and cannot take the volatility of the market in their stride.
Moreover, the returns provided by aggressive hybrid funds are taxed at a concessional rate of 12.50% and thus provide better after-tax returns to retirees. Since all of the funds accumulated by retired people are not needed at one go immediately, and as returns of aggressive hybrid funds are less volatile, aggressive hybrid funds come to the rescue of retired people, especially when interest rates are coming down on all the debt products.
Even for people with a slightly lower risk profile, aggressive hybrid funds are a better choice than pure large-cap equity funds. For people with a higher risk profile, other categories like midcap funds or small-cap funds may offer better returns, accompanied by a higher risk of short-term volatility.
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Balwant Jain is a tax and investment expert and can be reached at jainbalwant@gmail.com and @jainbalwant on his X handle.
Disclaimer: The views and recommendations made above are those of individual analysts, and not of Mint. We advise investors to check with certified experts before making any investment decisions.