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Asset allocation: Is an aggressive hybrid fund better than an equity and debt funds combination?

Is a hybrid fund better than a combination of equity and debt funds? Learn more about the benefits of aggressive hybrid funds & who should invest in them.
Equity-debt-funds-or-aggressive-hybrid-funds.

Karan is a 30-year-old individual with an aggressive risk profile. Asset allocation requires Karan to diversify his investment portfolio across multiple asset classes such as equity (major allocation) and some allocation to debt, gold, real estate, etc. Also, Karan will need to rebalance his investment portfolio regularly to maintain the percentage allocation to each asset class. Regular portfolio rebalancing can be a challenge for retail investors like Karan. Also, portfolio rebalancing has capital gains tax implications. 

What if retail investors with an aggressive risk profile like Karan get an opportunity to invest in equity and debt in a single financial product? What if the regular rebalancing is done by an expert, and that too without capital gains tax implications for the investor? Yes, that is what an aggressive hybrid fund provides you. In this article, we will explore what an aggressive hybrid fund is, how it works, its benefits, returns, taxation, etc. We will also understand whether a single aggressive hybrid fund is a better choice for an investor than an equity and debt fund combination.

What is an aggressive hybrid fund?

An aggressive hybrid fund is an open-ended hybrid fund that predominantly invests in equity and equity-related instruments along with some allocation to debt instruments. The equity allocation ranges from 65% to 80%. The debt allocation ranges from 20% to 35%. Since the equity allocation is always at 65% or higher, these funds are treated as equity funds from a taxation point of view.

As the equity allocation is higher, these funds are suited for investors with an aggressive risk profile. With a small debt component, these funds are relatively less risky than pure equity funds. Due to the high equity allocation, these funds have the potential to give inflation-beating high returns and generate wealth for investors.

Graph: Returns of aggressive hybrid funds are comparable to large-cap equity funds

The above table shows that aggressive hybrid funds have given returns comparable to large-cap equity funds over the long run (5 to 20 years). However, due to the debt component, the risk profile of aggressive hybrid funds is relatively lower than large-cap equity funds.

How does an aggressive hybrid fund work?

As discussed above, an aggressive fund allocates a higher portion of its money to equities and some to debt. When the stock markets are doing well, the equity component can generate high returns and create wealth for investors. When the stock markets fall sharply, the debt component can cushion the impact on the overall scheme portfolio. The debt component provides stability during adverse or uncertain times. Thus, an aggressive hybrid fund provides the best of both (equity and debt) worlds through a single financial product.

Portfolio Rebalancing

In an aggressive hybrid fund, the fund manager regularly rebalances the equity and debt component. When stock markets are doing well, the equity proportion will go up. During such times, if the fund manager feels the equity valuations are stretched, they will sell equities and reinvest the proceeds in debt. The fund manager may consider various factors such as price-to-earnings (P/E), price-to-book (P/B) or others to evaluate the equity valuations. Accordingly, they can take a call on whether to buy or sell equity. Similarly, when the equity market is falling, if the fund manager feels the equity valuations are favourable, they may sell debt and reinvest the proceeds in equity.

The portfolio rebalancing exercise is done regularly or during events when the stock market rises or falls sharply. The portfolio rebalancing is done at the scheme level; hence, it has no capital gain implications for the scheme investors.

Chart: Downside protection in aggressive hybrid funds

The above chart shows how aggressive hybrid funds have provided downside protection to their investors compared to large-cap funds during stock market corrections.

Performance of aggressive hybrid funds

Let us look at the performance of the top five aggressive hybrid funds.

Note: The above returns are as of 23 September 2022. The returns are for direct plans with growth option. The one-year returns are absolute. The three and five-year returns are CAGR. The funds have been ranked based on five-year returns.

The above table shows how the top five aggressive hybrid funds have given returns in the range of 13 to 20% CAGR in the last five years. These are good returns.

Taxation of aggressive hybrid funds

Aggressive hybrid funds always have a minimum allocation of 65% or higher to equities. As a result, aggressive hybrid funds are considered equity funds from a taxation point of view.

1. Short-term capital gains (STCG) tax

If you sell your aggressive hybrid fund units within twelve months of purchase, the profits will be categorised as short-term capital gains (STCG). The STCG will be taxed at a flat rate of 15%.

2. Long-term capital gains (LTCG) tax

If you sell your aggressive hybrid fund units after twelve months of purchase, the profits will be categorised as long-term capital gains (LTCG). The LTCG will be taxed at 15% without indexation.

Things to consider when investing in an aggressive hybrid fund

Some of the factors that you should consider when investing in an aggressive hybrid fund include:

  1. Risk profile: Aggressive hybrid funds have a high equity component (65 to 80%). Hence, they are suitable for investors with an aggressive risk profile. You should consider them for investment only if you have an aggressive risk profile.
  1. Investment time horizon: Since aggressive hybrid funds have a high equity component, they are subject to volatility in the short term. Equities are vulnerable to sharp corrections in the short term. Hence, you should consider investing in aggressive hybrid funds only if your investment time horizon is five years or higher.
  1. Financial goals: Aggressive hybrid funds are suitable for investing towards long-term financial goals such as building a fund for a child’s higher education or a retirement fund where the investment time horizon is five years or higher.
  1. Expense ratio: An aggressive hybrid fund gives you exposure to two asset classes (equity and debt) and involves regular rebalancing. Hence, the expense ratio may be on the higher side. When evaluating aggressive hybrid funds for investment, you should consider and compare the expense ratio, among other things.

Should you choose an aggressive hybrid fund instead of an equity and debt fund combination?

As per asset allocation, you will have to diversify your investment portfolio. As an investor with an aggressive risk profile, you can either go for an equity fund (majority allocation) and debt fund (smaller allocation) combination or a single aggressive hybrid fund. A single aggressive hybrid fund gives you the convenience of having both asset classes (equity and debt) in a single scheme.

If you go for an equity fund and debt fund combination, you will have to regularly rebalance your investment portfolio to maintain the allocation to each asset class. However, while rebalancing, any buying/selling of the equity and debt fund units will have capital gains tax implications for you as an investor. However, in an aggressive hybrid fund, the portfolio rebalancing is done for you by an expert fund manager. Also, since the rebalancing is done at a scheme level, there will be no capital gains tax implications for you as a scheme investor.

Hence, if you are an investor with an aggressive risk profile, you should give preference to an aggressive hybrid fund over an equity and debt fund combination. An aggressive fund gives you the best of both worlds, convenience, and has no capital gains tax implications for you during portfolio rebalancing.

Investing in mutual funds with the Glide Invest App

In this blog, we have explored aggressive hybrid funds, how they work, the returns generated, taxation, and whether you should invest in them. You can partner with the Glide Invest App for your financial planning journey to get recommendations for the appropriate mutual fund schemes based on your risk profile. You will get advice on planning and systematically investing towards your financial goals

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