In this post, I discuss how balanced advantage funds are different from aggressive hybrid funds and when and how investors should choose from these categories. One of the wrong questions that investors ask is, “how much return can I expect from this fund or this category of funds?”. Well, they should first be asking, “how much risk can I expect from this fund or fund category?”
The reason is simple: classification of funds into categories is based on risk and not return and this is true of all asset classes – stocks, bonds, gold, currency. However such risk classification is not always as simple as we will see below for Balanced Advantage vs Aggressive Hybrid Funds and this means return classification is impossible. This is why investors should understand what the different types of hybrid fund available, where can each invest and where are they placed in the risk vs reward (return) space. So let us start with the basics.
What are hybrid mutual funds?
These are mutual funds that invest in 2 or 3 different asset classes at any time: stocks + bonds or stocks + derivatives (arbitrage) or stocks + bonds + gold. In terms of taxation, they are either like equity funds or non-equity funds and can even switch between the two. Want to know what arbitrage is? See: How Arbitrage Mutual Funds Work: A simple introduction
If you want to understand the difference between an equity and non-equity fund and the latest tax rules, see:
What are the different types of hybrid funds?
- Hybrid Aggressive funds (min 65%-80% in stocks + bonds)
- Hybrid Arbitrage (arbitrage + small amt of bonds)
- Balanced Hybrid (40-60% stocks with no arbitrage)
- Conservative Hybrid (10-25% stocks and rest in bonds)
- Dynamic asset allocation aka Balanced Advantage (variable stock and bond exposure)
- Equity Savings (min 65% equity much of it will be arbitrage)
- Multi-Asset allocation (min three asset classes with 10% min exposure in each)
For this study, we consider at least 3-year old hybrid funds. The balanced hybrid category does not have any such fund (since many underwent changes after the SEBI fund category regulations) and is not considered. Thankfully many funds in the balanced hybrid are thematic – aimed at child education, retirement or age-based asset allocation. So you can straightaway avoid these.
Balanced Advantage vs Aggressive Hybrid Funds
The essential difference between balanced advantage and aggressive hybrid is the equity asset allocation. In a balanced advantage fund, the equity allocation can swing from 80% to 40% depending on market conditions. In an aggressive hybrid fund, the equity allocation will at least be 65%. Here, by equity allocation, I am referring to non-arbitrage holdings.
This should, in principle result in a good differentiation between risk and reward. Unfortunately, that is not the case as we shall see below. This is the reason, investors should be really careful in choosing and using these funds.
Risk vs Return: The general pattern
The following is how returns fluctuate with increasing risk.
Notice that the cone gets wider with increasing risk. This means that as risk increases, the spread in possible returns increases. This is what risk actually means. If a sales guy tells you that you can expect 15% return from this fund “over the long term”, she actually means, 15% +/- 10% so anywhere between 5% to 25%. What you end up with is potluck.
Risk-reward spectrum for hybrid mutual funds
Our tasks will be to try and reproduce the above schematic with real data for hybrid funds. I have taken all rated hybrid funds from value research (in the assumption that they have not changed character after the SEBI categorization). Listed their 3-year volatility (standard deviation) and 3-year return.
Then I created an upper return band: 3Y return + standard deviation (red dots) and a lower return band: 3Y return – standard deviation (black dots)
First, notice that the upper and lower return points fall on top of each other for the arbitrage funds. This essentially means that the risk for them is quite low. In fact, they are found on an island on their own. As we move right, the risk increases and the band quickly separate and move apart.
Notice, how risk equity savings funds are. Be very careful of these as returns could be negative. Unfortunately many so-called conservative hybrid funds are equally volatile (some more!).
The multi-asset allocation funds are all over the place! Making them virtually unclassifiable in term of risk or reward.
The balanced advantage or dynamic asset allocation funds overlap considerably with the aggressive hybrid funds and that is such a shame at least as of now.
When and how to choose Balanced Advantage funds?
Only for the long-term at least 7 years away with the right asset allocation. About 40% between 7-10 years (only for the first few years) and not more than 60% above 10 years. Use if you prefer lower volatility. However, you must make it a point to select funds with low volatility. For example ICICI Prudential Balanced Advantage Fund: Performance With Low Volatility. This has a standard deviation (x-axis) of about 8%. So you can spot where it is in the above graph.
Never choose monthly dividend plans of balanced advantage funds! It will destroy your wealth.
A balanced advantage fund with low volatility can help you sleep better.
When and how to choose Aggressive Hybrid funds?
Use only for long-term goals with asset allocation as above, but if you are an aggressive investor. I would recommend that you use for 10+ year goals only. So you can look for a volatile aggressive hybrid fund (high standard deviation). However, please keep in mind the associated risk.
Watch the video version of this post.
When and how to choose arbitrage funds?
You can treat them as a tax-efficient debt component of a long-term portfolio. Use them for generating income. I have written about this in great detail before:
- Generating tax-free income from arbitrage mutual funds?
- Choose arbitrage funds from my handpicked mutual funds september 2018 (PlumbLine)
When and how to choose conservative hybrid funds?
Don’t choose them! You don’t need them!
When and how to choose equity savings funds?
Avoid! If you must, use them for 7Y+ goals in moderation about 40%.
When and how to choose multi-asset allocation funds?
Again, avoid. You can consider a fund with tactical asset allocation strategy like the erstwhile ICICI Dynamic fund (now a multi-asset allocation fund), but tread with caution. Use only for long-term goals and if you are a conservative investor who believes in equal diversification across stocks golds and bonds rather than dynamic asset allocation (of course not all funds practice equal allocation).
This is confusing! What should I do?
Do not look at the funds! Look within yourself! Define your need clearly and the answers will be easy. Once you list your goals, use the Freefincal Robo Advisory Software Template. It will give you a start-to-finish financial plan along with the list of products to invest in PlumbLine
Wish you all a happy and safe Deepavali and Diwali