We have seen stock markets gaining huge traction post covid. Retail investors' participation in stock markets have gone up multi-folds thanks to social media websites like Twitter, YouTube and Instagram playing an important role in educating investors about investing in stock markets. With that being said, stock markets in their very nature are volatile and not suitable for investors who cannot digest this volatility.
The long term trends in stock markets have been positive but there is a good chance of losing money in the short term. Investors looking for higher than fixed deposit returns along with lower volatility find it difficult to invest in an equity oriented mutual fund or direct stocks.
In today's post, we are going to deep dive into a category of mutual funds that offers better than fixed deposit returns with lower volatility than equity oriented mutual funds.
Conservative Hybrid Funds
As the name suggests, a conservative hybrid fund is a fund that has a mandate to invest 75% to 90% of their total assets in debt instruments, and the rest 10% to 25% in equity. The word conservative is used because a majority of its assets are invested in debt securities, which are considered to be highly safe avenues.
This means that a conservative hybrid fund will invest the majority of portion into fixed income instruments like bonds, treasury bills, commercial papers, debentures along with a small portion into stocks. The fund manager rebalances the portfolio to maintain a conservative allocation on overall portfolio level.
Such a portfolio that has a combination of fixed income and equity will give you stability as a minimum of 75% is invested in fixed income securities & also growth as the remaining portion is invested in stocks.
Let us discuss important aspects of conservative hybrid funds:
Advantages of conservative hybrid funds
- FD beating returns: Conservative hybrid funds have delivered higher return when compared to fixed deposits due a small exposure towards stocks.
- Lower volatility: Having predominant exposure towards fixed income securities, conservative hybrid funds have lower volatility than equity oriented funds.
- Beginner friendly: Not just to generate FD beating returns, conservative hybrid funds can be a good starting point for first time investors to test their risk appetite in the stock market.
Who should consider invest in conservative hybrid funds
- Investors with an objective of generating higher returns than a fixed deposit.
- Investors who are nearing their retirement.
- Investors with short term goals of 3-5 years.
Tax treatment for gains on conservative hybrid funds
Being a fund with major chunk invested in debt instruments, gains on conservative hybrid fund are taxed as a debt fund in following manner:
- Short-Term Capital Gain Tax: If you redeem your investments within 3 years, then it is termed as Short Term. These gains or profits are added to your income and are taxed according to the tax slab applicable to you.
- Long Term Capital Gain Tax: If you redeem your investments after 3 years, the gains are classified as Long Term Capital Gain. Such gains are taxed at the rate of 20% percent along with indexation benefits.
Ideal investment horizon
Considering the equity portion of conservative hybrid funds, Investors should invest for a minimum horizon of 3 years. Also the tax outflow on gains will be lower in the case of holding periods above 3 years due to the benefit of indexation.
Important points to consider before finalising a conservative hybrid fund for investing your money
Investment risk: Even though 75%-90% of money in conservative hybrid funds is invested in fixed income securities, the remaining portion of the fund will be market linked and returns can be highly volatile in case of bear market.
Furthermore, the fixed income portion is also subject to interest rate risk that comes due to changes in interest rates in the economy. Hence, it is always suggested to have an investment horizon of minimum 3 years in order to play out any short term events.
Scheme specific mandate: Mutual fund schemes have predefined mandates regarding the types of securities they can invest in. This can be found in the scheme information document of the fund. It is important to check the type of fixed income securities that the fund can invest in and also the type of shares that fund will invest in to ensure that it is in-line with investor's risk appetite.
Expense ratio: Expense ratio is very important especially in case of debt oriented mutual funds. Expense ratio can range from 0.30% - 2% in case of conservative hybrid funds. This expense ratio is charged on the assets of the fund. A higher expense ratio will lead to lower returns & hence investors should avoid a fund if it is charging very high expense for management.
One can always approach an advisor to check if a particular scheme is suitable for his risk appetite before taking a call on whether to invest or not.
CA Rohit J. Gyanchandani is Managing Director, Nandi Nivesh Private Limited, A Pune based Wealth Management Company.