Last Updated on June 3, 2021 at 10:17 am
Sriram asks, “Instead of separately investing in equity mutual funds and fixed income and then worry about rebalancing and pay taxes, why not use just one aggressive hybrid mutual fund for long term goals? This has both equity and fixed income. The rebalancing is automatic, and we do not have to pay tax”.
On its face, it seems like a good idea and, in principle, definitely possible to pull off. However, aggressive hybrid funds are only a notch or two less volatile than equity mutual funds. For example, the max loss in a portfolio investing in the CRISIL 65% Equity 35% Debt Hybrid Index is 17% for five year periods between Jan 2011 and June 2021.
If the portfolio only had Nifty 500, then the max loss would be 29% during this period. That is, the Aggressive Hybrid Index suffers about 60% of the equity index loss. When stated like this, this seems obvious and trivial. If we extend the study period to the mid-’90s and the investment tenure to 15 years, the max loss for the equity index is 60%.
If we assume the hybrid index suffers 60% of 60% loss, it is still 36%. It is one thing to do a backtest and report this and quite another to invest in one fund and see its value erode by that much. More importantly, the equity allocation of aggressive hybrid mutual funds is typically higher than 65% by about 5-20% more. So the losses would be more.
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For the 5Y study, the max time during which the agg-hybrid fund was underwater was about 5 months. Just one month less than a 100% equity portfolio. Now for the 15Y study, the 100% equity portfolio was underwater for 40 months. Even if we (incorrectly) assume that the agg-hybrid fund portfolio would only be underwater for 60% of that period, it is still 24 months or two years.
The 100% equity portfolio volatility over 5Y as measured by the standard deviation is between 23% (max) top 12% (min). The corresponding numbers for the agg-hybrid portfolio are 16% (max) to 8% (min).
Even investors who claim this volatility and downside are acceptable to them will have to consider another debt option in a few years to de-risk the portfolio as it approaches the goal deadline. This de-risking is a continuous process that must begin well in advance.
A one-fund portfolio with an aggressive equity fund would be just as volatile as investing in an equity mutual fund for most investors. Therfore we recommend that investors treat aggressive-hybrid funds as pure equity funds (disregarding the debt component) and include them only as part of a balanced asset allocation with regular rebalancing and continuous de-risking; for example, 50% to 60% aggressive hybrid funds and the rest in fixed income. Fear of paying tax (or saving tax) should never be the primary consideration for deciding investment choices.
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