Hybrid funds are a category of mutual fund schemes that invests in two or more asset classes, particularly equity and debt. While there are various types of hybrid funds, we will be focusing on balanced advantage funds (BAFs).
BAFs are a type of hybrid mutual fund designed to keep the ‘balance’ between risk and returns.
Also known as dynamic asset allocation funds, BAFs invests mainly in equities and debt, which are managed or rebalanced periodically based on the current state of the market. In addition, these funds may invest in derivative instruments as a risk-hedging mechanism.
Mutual funds, in general, put a certain amount of investment money into debt and equity. And the allocation of these two varies, depending on whether they are equity-focused or debt-focused funds. Once invested, the asset allocation would stay as it is.
Similar to other mutual funds, BAFs invest parts of their corpus in debt and some in equities. However, once equity prices gain too much, they automatically change from equity to debt. Furthermore, they have better timing when going in and out of equities.
Understanding BAFs Further
BAFs aim to take ‘advantage’ of equities’ potential to generate higher returns while keeping the balance on risk by including debt to its portfolio when equity prices are not as attractive.
What makes these funds unique is that they don’t have a pre-determined restriction on asset allocation between debt and equities. Instead, they are handled dynamically. That is, they bought equities at a relatively reasonable price.
Conversely, they invested in equities at a high price and sold them at a higher price. But when equities can’t be bought at a discount, that’s the only time BAFs can go for debt.
Fund managers usually rely on what is called the Asset Allocation Model to determine such a change between equity and debt.
Asset allocation models are mathematical models created in-house by asset management firms to come up with a suitable equity-debt allocation taking into account current market conditions.
Such models are often a product of the fund manager’s hypothesis on future profit forecasts, historical data, and other factors that can help investors achieve maximum returns over the long term. That occurs dynamically depending on the strategy the funds used.
BAFs’ Bull and Bear Strategy
The strategy each BAF uses for investing their corpus can usually be found in the documents.
BAFs can choose to follow a procyclical strategy, which is an investing method that bulls or stock market optimists use where they buy high and sell at much higher prices.
However, such funds practicing that strategy are not a good fit for short-term investors who prefer to play it safe. That’s because procyclical BAFs tend to be riskier and can carry the risk of stock prices declining just after purchasing them at a high price.
If you’re an investor with a medium- or long-term horizon, you may have a better chance of making money with these funds.
Now, if taking a risk is not your cup of tea in investing, there are BAFs that follow a bear or counter-cyclical strategy. That means they buy stocks at reduced prices and sell them once their prices start rising. Such funds provide a less risky option.
BAFs and Hybrid Funds
BAFs and balanced or hybrid funds are two different investment vehicles. Unlike BAFs, balanced or hybrid funds have a pre-determined ratio of equity and debt allocation that is fixed. That means the ratio stays the same throughout the fund’s tenure.
Moreover, the returns earned by BAFs are higher compared to a debt hybrid fund, mainly due to the reason that equities make up a big part of their portfolio. Still, the potential returns of BAFs can be lower than a pure equity fund, as they have a bit of a debt component.
Suitable Investors of BAFs
BAFs can be an excellent option for investors looking to put money into mutual funds that offer more returns on equities but prefer to avoid the significant risk associated with investing directly in equities or pure equity mutual funds.
Furthermore, their potential returns are usually higher than a pure debt or hybrid fund, and their risk profile is only a tad higher than those funds.
BAFs also don’t carry as much risk as pure equities or equity-focused funds. And the risk can further reduce when you’re investing in the medium- or long-term. If you’re investing in BAFs, consider a three- or five-year period so you can reap the benefits offered by these funds.
You can add BAFs to your investment options if you’re aiming to earn excellent returns with capital appreciation while keeping your losses in check in case the markets move against you.
You can also opt for these funds if you’re a first-time mutual fund investor seeking a long-term investment avenue for wealth building.
Taxation of BAFs
As BAFs have a similar structure to equity funds that they must maintain, they need to ensure that even when these funds reduce their investments in equities, the combined equity and arbitrage represent at least 65% of the corpus.
BAFs are generally considered equity-oriented funds for taxation purposes. As a result, the long-term capital gains on these funds are taxed at 10%, while short-term capital gains are taxed at 15%. The taxation on BAFs is often better than pure debt or other investments, such as fixed deposits.
Final Thoughts on BAFs
BAFs are a form of hybrid mutual fund schemes that bet on equity and debt, with their asset allocation subject to change depending on the market valuations.
They are perhaps the best type of hybrid mutual funds you can consider if you’re a beginner investor who prefers to avoid risk at the start of your journey and is looking at having your money invested for three or five years.
These funds can provide you with consistent, regular passive income and can also be helpful to your retirement fund.
Before investing in any BAF, you must first carefully assess your risk appetite, financial goals, and liabilities. Then, if necessary, you should consult with a financial advisor to further examine and understand your available options.