Pure play equity and debt funds are staple, but you could also invest in a hybrid fund from the six categories defined under the Securities and Exchange Board of India regulations

Most portfolios are allocated using pure play equity and debt funds. The reason is the contours of pure play funds are better defined. For instance, in a large-cap fund, a minimum 80 per cent has to be in large-cap companies. In a multi-cap fund, minimum 25 per cent has to be in each of large, mid- and small-cap companies. In a corporate bond fund, minimum 80 per cent has to be in instruments rated AAA or AA+.

In contrast, in hybrid funds, the definition is about allocation to equity and debt. The details, such as market cap of equity stocks, or maturity and/or credit rating of bonds, are not defined.

As a consequence, when you invest in a specialised equity or debt fund, you have a better idea of what you are getting into. Having said that, hybrid funds have an appeal. Here, we discuss the six hybrid funds defined in the Securities and Exchange Board of India (Sebi) regulations.

Equity-Oriented Hybrid Funds

Of the six hybrid funds categories defined by Sebi, some are oriented to equity. Aggressive hybrid funds have allocation to equity in the range of 65-80 per cent. There is a regulation to this. It is compulsory to have this allocation to equity. Hence, this category is just one notch below a pure play equity fund. Then there is a category of balanced hybrid funds as well, with equity allocation of 40-60 per cent of the portfolio.

However, as per the Sebi regulation, an asset management company (AMC) can have either aggressive or balanced hybrid fund, but not both. Given that a fund with more than 65 per cent allocation to equity is taxed as equity and investors prefer equity taxation, AMCs have picked aggressive hybrid funds over their balanced counterparts.

Though Sebi defines dynamic asset allocation or balanced advantage funds as “investment in equity and/or debt that is managed dynamically”, the way the AMC industry has positioned these funds—BAF funds as these are referred to—is a bit different.

The equity component is maintained at more than 65 per cent to be eligible for equity taxation. A part of the equity exposure is also hedged. The hedging is done by taking a contra position, i.e. sell / short position in stock futures. Sometimes the contra position is taken through index futures as well. The effect of the sell / short position is that the net equity exposure is that much lower.

As an illustration, let us say that in a BAF of Rs 100, equity exposure is Rs 80 and debt exposure is Rs 20. There is a short position in equity of, say, Rs 40. Thus, the net equity exposure is Rs 40. The extent of the hedge is decided by the fund manager, as per the reading of equity market valuations. The reason to make the net equity exposure lower than the apparent exposure is to make it defensive. If the equity market were to correct itself, the adverse impact would be to the extent of Rs 40 and not Rs 80, in our example.

Multi-asset funds (MAFs) have been defined to have exposure to minimum three asset categories and a minimum of 10 per cent in each asset category. Here, too, most AMCs run portfolios with equity exposure more than 65 per cent, to be eligible for equity taxation. The remaining component is invested in debt and gold, or may be in some other asset category. Only a few AMCs run their MAFs with equity less than 65 per cent.

Debt-Oriented Hybrid Funds

Conservative hybrid funds have equity exposure in the range of 10-25 per cent of the portfolio. With limited exposure to equity, these are fixed-income or debt-oriented.

Arbitrage funds earn returns from the price differential between equity stocks in the cash market and stock futures market, for 65 per cent of the portfolio. The price at which a stock is sold in the stock futures market is higher than the price at which it is purchased in the cash or spot market.

From a technical point of view, arbitrage funds have 65 per cent or more of the portfolio in cash futures arbitrage, and 35 per cent or less in debt or money-market instruments. However, from a practical perspective, these funds may be seen as akin to fixed-income funds, as there is no directional call on equities. Returns do not come from the equity market moving up, but from the price differential between the two segments of the market.

In equity savings funds, the Sebi regulation states a “minimum investment in equity and equity-related instruments (65 per cent of total assets) and minimum investment in debt (10 per cent of total assets). Minimum hedged and unhedged to be stated in the SID (scheme information document).”

Here the implication is that there has to be a usual or unhedged exposure to equity, and a hedged exposure to equity (similar to arbitrage funds), adding up to minimum 65 per cent of the portfolio. The industry practice is that the usual equity component is maintained in the range of 20-40 per cent, and so is the hedged portion. Though technically equity savings funds are equity funds, the equity (unhedged) portion being in the range of 20-40 per cent, these are more like fixed-income or debt-oriented funds.

Summary Of Equity Exposure

• Arbitrage funds, though technically equity funds, effectively do not have any equity exposure as they are completely hedged through stock futures.
• Conservative hybrid funds have 10-25 per cent of equity exposure.
• Equity savings funds have 20-40 per cent equity (unhedged) exposure, varying from AMC to AMC.
• BAFs have equity (unhedged) exposure of 30-60 per cent of the portfolio, varying with each AMC.
• In multi-asset funds, equity exposure depends on the AMC, mostly it is more than 65 per cent.
• Aggressive hybrid funds have allocation to equity in the range of 65-80 per cent of portfolio.

Taxation

Certain fund categories are clearly equity, like aggressive hybrid, by virtue of having more than 65 per cent of portfolio in equity. Certain categories are clearly debt, such as conservative hybrid, as they have less than 35 per cent in equity.

Certain fund categories are considered equity for taxation, such as arbitrage funds, equity savings funds and BAFs (as run by AMCs). However, being defensive on equity exposure, these may be utilised accordingly.

Conclusion

If you want to maintain a certain level of equity exposure, you may use a relevant hybrid fund. Within the Sebi defined equity ranges, there is tracking and decision-making by the fund manager. After the removal of indexation benefit from debt funds from April 1 2023, a section of investors prefer hybrid funds. But, note that while shifting from debt to hybrid, the overall equity:debt allocation in the portfolio should not get distorted.

By Joydeep Sen, Corporate Trainer and Author