A fund which invests in both equity and debt is called a hybrid or balanced fund. However, there are many types of hybrid funds and distinguishing between them can get quite confusing. One major dividing line in this category is between ‘dynamic allocation funds’ and ‘equity-oriented hybrid funds’.
In dynamic allocation funds, the fund manager has the flexibility to adjust the fund’s equity and debt allocation based on his view of the markets or as per a pre-existing formula. In equity-oriented hybrid funds, this leeway is a given but is typically circumscribed by a requirement of maintaining a minimum 65% of the fund’s corpus in equity. This requirement comes from the need to maintain its tax status as an equity fund.
Dynamic allocation funds try to move more money into equities when markets are at low valuations and vice versa. Hybrid equity-oriented funds, on the other hand, as per their mandate, have equity allocations at a minimum of 65% at all times. This allows them to be classified as equity funds for tax purposes and be subject to a 15% short-term capital gain tax and a nil long-term capital gains tax. The balance money in these funds is held as debt or cash. The following table gives a sense of how the two kinds of funds differ in terms of allocation:
Dynamic Allocation Funds
|Dynamic Allocation Fund (Regular Plans)||Equity (%)||Bond (%)||Cash (%)||Other (%)|
|Franklin India Dynamic PE Ratio Fund Of Funds Growth||37.85||54.09||8.05||0|
|HDFC Dynamic PE Ratio Fund of Funds- Plan A Growth||51.09||41.49||7.05||0.37|
|IDFC Dynamic Equity Regular Growth||48.36||21.65||30||0|
|DSP BlackRock Dynamic Asset Allocation Fund Regular Growth||40.66||54.18||5.16||0|
|Kotak Asset Allocator Fund Growth||9.33||71.15||19.52||0|
|Hybrid Equity Oriented Fund||Equity||Bond||Cash||Other|
|Aditya Birla Sun Life 95 Balanced Fund Growth||73.09||21.13||5.72||0.06|
|Franklin India Balanced Fund Growth||67.16||31.83||1.01||0|
|ICICI Prudential Balanced Advantage Fund Growth*||37.04||23.29||39.66||0|
|HDFC Balanced Fund Growth||69.63||27.18||3.08||0.12|
|Tata Balanced Fund Regular Growth||73.32||23.97||2.71||0|
(Source: Morningstar; Data as on 4th December 2017)
*Actual equity allocation is higher to meet the norm of 65% equity. However, the fund’s derivatives strategy effectively reduces it to the given proportions.
**Lower than 65% on account of the derivatives strategy in ICICI Prudential Balanced Advantage Fund
As you may have noticed, average equity holdings for dynamic allocation funds are less than 40%. This is in all likelihood due to a broad consensus among fund managers that current markets are at high and unreasonable valuations, making equities a risky bet. The fund managers of hybrid equity oriented funds cannot follow suit even if they share the same view because of the fund mandates.
One exception here is what is known as a balanced advantage fund which uses the ‘derivatives loophole’. In this type of fund, the manager maintains an equity allocation of above 65%, however, he uses derivatives strategies to effectively modify this to a much lower figure. For instance, if a fund buys a stock and sells its futures at the same time, the net position is akin to that of debt rather than equity.
So how does allocation affect associated risks and, more importantly, the performance of said funds? The following tables will give you a sense of just that:
Dynamic Equity Allocation Fund Performance
Hybrid Equity Oriented Funds Performance
(Source: Morningstar, 4th Dec 2017)
As you can see, the average performance for both three-year and year-to-date periods has been higher for hybrid equity-oriented funds.
Standard deviation is another critical factor that should be considered. It is simply the volatility of the fund’s returns in relation to its returns. It indicates how much returns can deviate from the historical mean return of the fund. For example, if a fund has an average rate of return of 10% with a standard deviation of 3%, then its return can theoretically range from 7% – 13%. Ideally, the lower the volatility, the more the fund is preferred.
|Dynamic Allocation Fund||3 Yr Std Dev||Hybrid Equity Oriented Fund||3 Yr Std Dev|
|Franklin India Dynamic PE Ratio Fund Of Funds Growth||6.66||Aditya Birla Sun Life 95 Balanced Fund Growth||10.16|
|HDFC Dynamic PE Ratio Fund of Funds- Plan A Growth||11.98||Franklin India Balanced Fund Growth||8.92|
|IDFC Dynamic Equity Regular Growth||5.78||ICICI Prudential Balanced Advantage Fund Growth||8.25|
|DSP BlackRock Dynamic Asset Allocation Fund Regular Growth||6.15||HDFC Balanced Fund Growth||10.14|
|Kotak Asset Allocator Fund Growth||5.87||Tata Balanced Fund Regular Growth||10.63|
(Source: Morningstar, Dec 4th, 2017)
As the table indicates, dynamic equity allocation funds have a lower standard deviation and hence a lower volatility.
So the million dollar question is, does the lower volatility justify the lower return? The returns in the dynamic allocation fund category range from 6 to 9% whilst the returns in the hybrid equity allocation fund category range from 8.5 to 11%.
On the flip side, the average volatility in the hybrid equity oriented category is also higher by 2%. So is this trade-off a fair one?
The answer to this question largely depends on you. If you can stomach a higher volatility of 2% for a higher return of about 2%, hybrid equity oriented allocation funds are the smarter choice. If not, look at dynamic asset allocation funds. A key element of stomaching the volatility is the willingness to stay invested through sunshine and rain, for sufficiently long periods of time (at least three years, as the date above shows). This is easier said than done and you must carefully evaluate whether you can do this.
Another major difference between these categories is taxation. Hybrid equity oriented funds are classed as equity funds for tax purposes and hence face a short-term capital gains tax of 15% (if sold in less than one year) and nil long-term capital gains tax (for holding more than one year).
Dynamic equity allocation funds are typically classified as debt funds. As a result, their short-term capital gains tax rate is as per your slab (which could be as high as 30%) and the long-term capital gain tax rate is 20% with the benefit of indexation.
So which is the right type for you? We hope you’re now in a better position to decide.