Wherever there is a tax angle to draw investors in, you can be sure that it is going to be put to excessive use! The case in point here is balanced advantage, multi-asset allocation, and other hybrid funds.
With the new taxation for debt funds (where they lose indexation benefits), hybrid funds are now being sold as substitutes for debt funds in terms of superior taxation (like equity, or with indexation benefits like debt funds used to be earlier). Besides, they have the seeming advantage of being an all-in-one category (equity, debt, gold). So, should you make the switch on these grounds?
What these funds are
All hybrid funds invest in two or more asset classes – equity (stocks), debt (bonds), and gold. Gold and debt balance equity risk. Equity helps generate superior returns. This equity that hybrid funds invest in comprises plain old stocks as well as stock or index derivatives, i.e., futures and options.
Funds take derivative exposure only on stocks already held in the portfolio and index derivatives. These are used to make the opposite call of what the fund takes in its stocks – what this does, essentially, is to neutralise or negate the equity risk.
The higher the derivative component of the portfolio (called hedged equity), the lower the equity risk.
The split between gold, debt, equity and derivatives changes with each fund category. Aggressive hybrid funds invest only in equity and debt with no derivatives. Balanced advantage and equity savings funds invest in debt and equity including derivatives. Multi-asset funds invest in all of them.
Funds decide how much to allocate to which asset class or derivative based on equity and debt market conditions. Aggressive hybrid funds are fairly stable and don’t change the equity-debt split much.
Multi-asset funds can, in theory, swing from very low to very high equity (and so in debt), and hold very low to even above 10-15% in gold. If stock markets correct, for example, funds can up equity allocation to take advantage of cheaper valuations. If debt markets show more promise, the fund can raise debt to go where returns are best.
Similarly, balanced advantage and equity savings funds can neutralise a large or entire part of their equity exposure with derivatives if markets are volatile and keep derivatives lower when markets perk up.
They offer better returns than debt funds and without full equity risk.
Taxation in all these categories is far lower than in debt funds.
All sounds good! But don’t jump just yet. Note these points first.
Not substitutes for debt
One, consider risks. As balanced advantage funds hedge equity risk, they may seem a low-risk product. But remember, the fund has unhedged equity at all times.
This can cause volatility and even losses in the short to medium term. They cannot, therefore, offer the kind of downside cushion diversification that a debt fund provides.
Multi-asset funds will aim to keep equity allocation steadily at 35% or more to maintain their equity-like tax status regardless of what equity markets do. In other words, they may not necessarily protect your portfolio when equity nosedives. Replacing them for debt might end up increasing your portfolio risk.
Further, within a category, each fund varies widely in allocations as fund manager views on markets differ.
So unless you choose a fund that is closest to your risk profile, it may turn out to be a bad fit.
Two, take diversification. Debt funds offer a variety of strategies and ways to invest in the opportunities that debt markets provide; equity funds, too, have a host of different styles all of which help build a diversified portfolio. Most hybrid funds, other than aggressive hybrid, are narrower in terms of strategies – for them, the primary point is the shift between asset classes and not different styles of picking stocks or bonds.
Three, take asset allocation. The equity-debt proportion is a call you should take based on your risk and timeframe. It is different for each person. It cannot be dynamic and cannot be left to a fund to decide on your behalf. And you cannot hope to achieve the all-in-one diversification that categories like multi-asset funds boast of, unless you put your entire money in this category!
How to use these funds
So, view these funds only as lower-risk ways of investing in equity. You can use them to reduce the risk of your otherwise high-risk equity portfolio. You can also use them for medium time frames where the risk of loss in this category is low and tax efficiency is also achieved. Remember that these funds need longer holding periods – minimum of 1.5-2 years for balanced advantage or equity savings funds and minimum of 3 years for multi-asset funds.
So don’t go by taxation alone to make investment decisions. Go by what that fund will do for your portfolio!
(The writer is co-founder, PrimeInvestor.in)