Are hybrid mutual funds less risky than equity mutual funds?

Last Updated on December 29, 2021 at 6:13 pm

Nearly three years have passed since mutual funds complied with the SEBI recategorization rules. We now have enough data to classify hybrid mutual funds in terms of their risk with respect to equity mutual funds. We shall use the standard deviation of monthly returns over the last three years to classify hybrid mutual funds.

Let us first go over the definitions of hybrid funds.  (1) Conservative Hybrid Funds: 10% to 25% equity and rest in debt. (2) Balanced Hybrid Funds: 40 to 60% equity without arbitrage and rest in debt. (3) Aggressive Hybrid Funds 65-80% equity. AMCs will be allowed to offer either an aggressive hybrid fund or a balanced hybrid fund, not both.

(4) Dynamic Asset Allocation or Balanced Advantage Fund: Variable asset allocation with no limits. (5) Multi-asset allocation: 10% of equity (including international equity), 10% debt and 10% gold and rest is variable. (6) Arbitrage funds are not “hybrid” funds! They only need to invest 65% in equity and equity-related investments. There is no minimum allocation requirement to arbitrage!

(7) Equity savings funds should have a minimum of 10% in debt and 65% in equity and equity-related instruments. The direct equity exposure limit within this 65% is variable but must be specified in the scheme document. How robust are these definitions?

As recently discussed, we cannot classify mutual fund in terms of returns. If there is a stock market crash in one year, debt funds would have beaten equity funds and vice-versa if there is a bull run. The spread in returns is too much to use as a classification metric: How to arrange mutual funds in terms of their returns?

So we turn to the volatility in monthly returns. In particular, how much do monthly returns deviate from the average monthly returns over the last 36 months? This is measured with the standard deviation. Higher the standard deviation, the higher the volatility (fluctuations) in the NAV of the mutual fund.

It must be understood that volatility is only one form of risk. Other types like credit risk and reinvestment risk will not manifest in the NAV until there is a credit event or change in interest rates (we are referring to liquid funds and money market funds here. NAV fluctuations in longer-term funds occur daily due to bond market supply-demand fluctuations).

The y-axis represents the standard deviation. The x-axis the fund number (not shown). First, let us locate the blue dots, the nifty index funds. They are clumped together and form a nice reference point.

Relative to this, the active large cap funds (brown squares) are on both sides. There is some spread, but not too much.  Next, the crosses – the multi-asset funds. They are all over the place, meaning there is too much freedom for fund managers. This category is poorly defined.

The equity savings funds (green dots) are a bit more volatile than conservative hybrid funds (red dots) but is just as volatile as dynamic asset allocation funds (denoted by +). The Balanced Advantage funds (grey dots) are also all over the place.

The aggressive hybrid funds (blue triangles) are just as volatile as active large cap funds. This is why I keep stressing that agg hybrid funds should be considered equity funds in asset allocation. IMO one should not add their debt allocation to the debt allocation in our portfolios.

The arbitrage funds are well-defined thanks to the arbitrage contribution! Now how do we define a conservative fund? It might be useful to many AMC fanboys who want to invent needs because their fav AMC is coming up with an NFO.

As per the last three years trailing data (this is variable as per the period considered), conservative hybrid funds are 2.5 to 3 rungs less volatile than aggressive hybrid funds and about 2 rungs more volatile than arbitrage funds. Is that useful? Not in the least!

The standard deviation of an arbitrage fund is comparable to that of an ultra short-term fund in the absence of any credit event or arbitrage event (when different securities are hedged). It is reasonable to classify arbitrage funds as “debt”.

It is also reasonable to classify aggressive hybrid funds (and even multi-asset) as “equity”. The rest, I am afraid, are somewhere in between.

Note about the arrows: Principal Arbitrage Fund suffered a credit default and has a higher standard deviation. HDFC Balanced Advantage Fund is only that in name. It typically has the higher volatility in its category. JM Large Cap Fund fell the least during March 2020 and has the lowest standard deviation. Close to 20% debt allocation is one reason for this.

Are hybrid mutual funds less risky than equity mutual funds?

To answer the titular question, for the last three years, the volatility of aggressive hybrid funds, arbitrage funds and multi-asset funds are reasonably well defined. They are either as volatile, a bit less volatile or significantly less volatile than equity mutual funds.

As for the rest of the hybrid categories, they are caught in between. Since the investor cannot clearly classify their volatility, they are riskier than equity funds due to incorrect perceptions.

Investors want the balanced advantage funds, dynamic asset allocation funds, equity savings funds or conservative hybrid funds to give “extra returns” during bull runs and not fall during bear runs. This is impossible. Since it is difficult to peg the risk level of these funds, I would treat them as riskier than equity funds.

Someday perhaps we might have index funds in these categories. Then things will become a bit more clear. Right now, there is too much room in the asset allocation to be confident about risk levels.