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What are Hybrid Funds: Benefits, Taxation and How to Invest

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What are Hybrid Funds: Benefits, Taxation and How to Invest

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What are hybrid funds?

Hybrid funds are mutual funds that invest in a mix of debt and equity instruments. The proportion of debt and equity investments may vary from one hybrid fund to another, but the defining feature of these mutual funds is the presence of these two asset classes in its portfolio.

Equity and debt mutual funds

Debt mutual funds invest in a bunch of debt instruments or fixed-income instruments like government or corporate bonds. Fixed income, here, means that you can make a fixed amount of returns on your investment. Often, this RoI is in single digits (like 7% for instance), but the returns are assured.

Equity mutual funds, on the other hand, are mutual funds that invest in equity like stocks of companies listed on the stock exchange. The returns you can make here vary over time and are tied to a number of factors such as the performance of these stocks, the general volatility of the market, and so on. The RoI you can make here is incredibly high - goes all the way up to 20% or more in some cases - but this isn’t a guarantee.

In addition to debt and equity instruments, some hybrid funds may diversify into other asset classes like gold. No matter which type of hybrid fund you choose, you benefit from diversification through a single investment vehicle.

How do hybrid funds work?

At the basic level, a hybrid fund works like any other mutual fund.

Investors pool in their money, and the mutual fund house invests this corpus in a common portfolio. A fund manager typically puts together the portfolio to align with the scheme's investment objective.

What's next?

Each investor is allocated a certain number of units in the fund based on the amount of capital they have invested individually. Every unit in the fund has a unit price, known as the unit's net asset value or NAV. It is calculated using the following formula:

NAV per unit of the fund = Net assets of the fund ÷ Total number of units issued

Over time, as the markets fluctuate and the value of the investments in the fund’s portfolio may increase or decrease. Consequently, the value of each unit in the fund also changes, thereby leading to gains or losses for investors.

Here’s an example of how this works. Let’s assume we have a mutual fund worth ₹1 crore.

Particulars

Details

Net assets of the fund

₹1,00,00,000

Total number of units in the fund

1,00,000

NAV per unit 

₹100

Amount you have invested in the fund

₹5,00,000

Units allotted to you

5,000 units

Now, at the end of 2 years, let’s say the key figures stand as follows —

  • The net asset value of the fund increases to ₹1,20,00,000
  • The NAV per unit will then grow to ₹120 each
  • Your investment value will now be ₹6,00,000

In other words, you would have gained ₹1,00,000.

On the other hand, if the NAV decreases, your portfolio will suffer a loss. This is how gains and losses work in a hybrid fund.

What are the different types of hybrid funds?

Hybrid mutual funds are a broad category of investments. If you dig a little deeper, based on the proportion of equity and debt instruments in the portfolio, there are several types of hybrid funds available for investors today. Each type of hybrid fund is suitable for a different kind of investor. Here’s a list:

Equity-oriented hybrid funds

Sometimes known as aggressive hybrid funds, these mutual funds invest a significant portion of their capital in equity. Usually, around 65% to 80% of the fund’s assets are directed towards equity instruments. The equity investments are typically diversified across top industries like BFSI, FMCG, real estate, healthcare, automobile, oil and gas, and others. The rest is invested in debt and money market securities, thereby offsetting the risk from equity to a certain extent.

Debt-oriented hybrid funds

These funds are the ideal choice for conservative investors who prefer to limit the overall risk in their portfolio. In this type of hybrid fund, over 65% of the assets are invested in debt instruments. Some common assets in this category include fixed-income instruments such as government bonds, debentures, corporate bonds, treasury bills, and other such options. The rest of the funds may be invested in a mix of equity instruments and cash and cash equivalents.

Monthly income hybrid funds

They are also best suited for conservative investors who are not keen on taking high levels of risk. As the name suggests, these mutual funds focus on offering investors a reliable monthly income. Also known as Monthly Income Plans (MIPs), these funds invest predominantly in debt. Around 15% to 20% of the assets may be invested in equity.

If you invest in these hybrid funds, you enjoy regular income as dividends. Although the fund's name is 'monthly,' you can generally choose various other dividend frequencies, such as quarterly, half-yearly, or annual payouts.

Arbitrage funds

Arbitrage is the process of buying and selling securities in different markets to take advantage of the price differences between these markets. An arbitrage fund is a type of hybrid fund that aims to maximise returns by purchasing an instrument at a lower price in one market and then selling it at a higher price in another market. But arbitrage trades may not always be possible, and these funds offset this volatility by also investing in debt instruments or cash and cash equivalents.

Benefits of investing in hybrid funds

Ideal asset allocation

Hybrid funds give you the ideal asset allocation by allowing you to invest in various asset classes like equity, debt and money market instruments. With just a single investment vehicle, you can access multiple asset classes and add them to your portfolio. You can choose the type of hybrid fund that offers optimal asset allocation for your financial goals.

Diversification

With hybrid mutual funds, you get the benefit of diversification beyond asset classes. Even within each asset category, your portfolio is diversified. For instance, the equity component may be diversified across market caps and industries, while the debt component may be diversified across different debt instruments. This distributes the risk optimally.

Made for various risk profiles

Hybrid mutual funds are also suitable for investors with varying risk profiles. There are different kinds of funds in this category, as we saw earlier, and you can choose the investment option that best suits your risk tolerance levels. If you are an aggressive investor, you can choose equity-oriented hybrid funds. On the other hand, debt-oriented hybrid funds may be a better choice if you want to limit the risk in your portfolio.

Automatic rebalancing

These mutual funds also give you the benefit of automatic rebalancing. You need not worry about your portfolio asset allocation deviating from the targeted asset allocation. This is because fund managers monitor how your mutual fund portfolio is affected by market movements, and rebalance the portfolio as and when it may be needed.

How are hybrid mutual funds taxed?

Hybrid funds contain both debt and equity components. So, the taxation of these funds will vary based on the components. Gains from the equity portion are taxed differently from the gains on the debt component.

Taxation of the equity component of hybrid funds

The equity component in hybrid mutual funds is taxed like all equity mutual funds, as follows:

Particulars

Tax rate

Short term capital gains (STCG) 

Taxed at 15%

Long term capital gains (LTCG) up to ₹1 lakh

Not taxable

Long term capital gains (LTCG) above ₹1 lakh

Taxed at 10% without indexation

Taxation of the debt component of hybrid funds

The debt component in hybrid mutual funds is taxed like all pure debt mutual funds, as follows:

Particulars

Tax rate

Short term capital gains (STCG) 

Taxed at your income tax slab rate

Long term capital gains (LTCG) 

Taxed at 20% with indexation or at 10% without indexation

How do you go about investing in hybrid mutual funds?

Investing in hybrid funds is easy. It is pretty much how you invest in any other mutual fund. You can choose any of the following ways to get started with your hybrid fund investment journey.

Offline investments made directly with the fund house:

You can directly invest in a hybrid fund by visiting the nearest branch office of the fund house. Submit the documents needed, fill in the application form and start investing.

Offline investments made through a broker:

Mutual fund brokers or distributors can also help you invest in hybrid funds. You can submit the duly filled application form and the documents your broker requires to start investing.

Online investments through the official website of the fund house:

Most leading mutual fund houses now offer the option to invest online in mutual funds. You must complete the KYC process and the due formalities to open an account and invest.

Zero-commission Mutual Fund investing on Fi Money

On Fi Money, you can invest in a wide range of hybrid mutual funds. You can use the filters on your app to select hybrid mutual funds based on your needs and invest at no additional cost.

In conclusion

If you have been thinking about adding mutual funds to your portfolio, hybrid funds may be a good option to consider. Remember to choose the type of hybrid fund that aligns with your financial goals and your risk profile.

Frequently Asked Questions

1. Are hybrid funds safe?

Hybrid funds invest in both debt and equity components. So, as expected, the equity investments carry market-related risks, but the debt component helps offset some of that risk. So, hybrid funds may be safer than investing directly in stocks, or even pure equity funds for that matter.

2. What are hybrid equity funds?

Hybrid equity funds are a type of mutual fund that invests in a mix of both debt and equity instruments. The proportion of equity is significantly higher in hybrid equity funds. Typically, around 65% of the portfolio consists of equity instruments, while the rest of the portfolio consists of debt instruments and cash and cash equivalents.

3. What comes under a hybrid fund?

Under the broad category of hybrid funds, we have different subcategories like equity-oriented funds, debt-oriented funds, monthly income funds and arbitrage funds. Each fund caters to a different kind of investor.

4. Who should invest in hybrid funds?

Any investor who is looking to diversify their investment portfolio easily, with just one or two investment options, can choose to invest in hybrid funds. If this sounds like something you’re looking for, you can browse through the various mutual funds in this category and choose one to invest in, based on the risk-return profile.

5. How are hybrid mutual funds taxed?

The equity component of hybrid funds is taxed like a pure equity fund, while the debt component is taxed like a pure debt fund.

  • STCG from the equity portion: taxed at 15%
  • LTCG above ₹1 lakh is taxed at 10% without indexation
  • STCG from the debt portion is taxed per your slab rate
  • LTCG is taxed at 10% without indexation or 20% with indexation

6. What are some key tips for investing in hybrid funds?

Before you invest in a hybrid fund, ensure that its asset allocation matches your risk profile. If you are a conservative investor, you may want to steer clear of aggressive hybrid mutual funds, and vice versa. Also, check the fund manager's skills, look at the fund's past performance and be aware of the taxation norms before investing.

You might want to check these out too!

Equity Mutual Funds - Basics, Types, Benefits and More

Small-Cap, Mid Cap, Large Cap Funds. A Brief Comparison

Mutual funds vs stocks

Best mutual funds to get assured dividends

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