Invest in hybrid funds for diversification

Designing a mutual fund (MF) portfolio is critical to achieving the goals of investment. A portfolio of MF always helps in risk management as market conditions vary continuously and all types of funds wouldn't perform across all conditions.

By creating a portfolio, one could create diversification of exposure to the markets and also possibly reduce the risk.

In general, while investing in equity MF, we tend to add funds of large, mid and small-cap stocks so that the investment is exposed across the breadth of the market.

A diversified or multi-cap fund is also added to give a different flavour to the overall portfolio.

Another important category of fund that certainly helps diversification is the hybrid funds. Hybrid funds as the name suggests is a mix of debt and equity in their portfolio.

Of course, this category is again sub-divided depending upon the extent of exposure to the equity. A higher exposure or majority i.e. about minimum of 65 per cent into equity is considered as an aggressive hybrid fund or equity-oriented hybrid funds as per the Securities Exchange Board of India (SEBI) guidelines.

The fund manager has the flexibility to go upwards of this limit depending on the market situations. On the other extreme is the conservative or debt-oriented hybrid funds where the asset allocation comprises of minimum of 60 per cent in debt instruments in the portfolio.

These funds being conservative in nature also have a decent proportion in cash and liquid related instruments. These funds are better suited for investors with lower risk profile but would like to take a bit of advantage from the equity volatility.

Then there is another sub-category within these hybrid funds is the arbitrage funds. These funds try to gain from the opportunity provided between the difference in cash and future markets.

The mispricing between these two markets i.e. spot and future markets are exploited to generate returns to the investors. These funds are again not of long-term in nature to be invested though they end up giving a debt-kind of returns with equity taxation.

So, while designing a MF portfolio, the investor could explore any or all of these funds depending upon the time horizon of the needs.

The very role of these funds in the portfolio is not only to take advantage of both the worlds (debt/equity; spot/future) but also to lower the risk of the entire portfolio.

An aggressive hybrid fund helps to reduce the risk by minimising losses during a market fall. Due to their very nature of portfolio construct the lower equity exposure relative to equity MF would limit the extent of equity market falls.

Conversely, in a bull or rising equity markets, the gains wouldn't be completely imbibed due to limited exposure to the equity in their portfolio.

The biggest advantage of these funds is the ability to switch the exposure to risk within the limits and participate in best of both the worlds.

The erstwhile monthly income plans (MIP) fall into the conservative hybrid category which allow one to generate an additional alpha (return) with the little exposure to equity.

The tax treatment however with these funds is similar to that of the debt MF and so investors should be aware of this when investing in conservative hybrid funds.

Even for young investors looking to generate wealth over longer periods of time, an aggressive hybrid fund finds a place in their portfolio.

At volatile market times like these they end up giving lower two-digit returns at a risk that's much lower than that of the pure equity MFs.

The debt investment returns provide consistency to the portfolio while the relatively higher equity exposure helps to generate returns in the long term.

These funds thus could be used as a diversification tool in-line with that of the multi-cap funds but with different expectations.

But, a dash of these funds surely would add a positive and desirous outcome to the overall portfolio.

(The author is co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)