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The Gold Equity Hybrid

A new hybrid fund is in the pipeline which will invest in both gold & equity, but will this be a good investment?

There's a new twist to the old idea of hybrid fund. Up till now, hybrid funds (also called balanced funds) meant a mix of equity and fixed income. Now, there's a new one in the pipeline-a fund that's a mix of equity and gold.

Let me first explain the logic of a hybrid fund and why it is better than doing a mix and match yourself. Two very basic ideas in investing are diversification and asset allocation. Diversification simply means that one must invest in a mix of investments that are likely to do balance out each other's bad times. Whenever one type of investment in a diversified portfolio does badly, others should do well. This ensures that the entire portfolio does not do badly simultaneously.

To some extent, diversification can also mean that the entire portfolio may not do well simultaneously but that's the price one pays for safety. Diversification is essentially a safety technique. What sharpens diversification in practice is asset reallocation. Asset reallocation means making sure that a pre-determined balance between various asset types is maintained.

For example, let's say that there is a mutual fund that is supposed to keep 25 per cent of investors' money in debt instruments and 75 per cent in equity. During a phase when equity is doing much better than debt, this balance will swing towards equity. Now, let's say that in a given period, equity gains 20 per cent and debt 2 per cent. This could easily happen in a hot equity market. Such a period will see this fund gain 15.5 per cent on the whole. However, the balance will shift to about 78 per cent equity and 22 per cent fixed income. At this point, the fund manager should sell off some equity and buy fixed income assets to bring the balance back to 75:25. This will effectively 'book profits', taking out money that you have earned and putting it in a safer place. In theory, you could do this yourself but that would take a lot of discipline. It would also leave you liable for taxes whenever you shifted taxes from one asset class to another.

Hybrid funds are available in a range of different balancing points. At one end are the so-called Monthly Income Plans (MIPs) that may have as little as 10 per cent equity. At the other end, there may be funds with 70 or 80 per cent in equity. Now, one AMC (UTI) seems to be preparing to launch a fund that will have around 65 per cent equity gold. The idea of combining gold with equity is an interesting one. Gold is generally believed to have an inverse relationship with equities. It is also believed to be a good asset type to hold during what may generally be described as bad times. For some time now, gold has generally done well.

Of course, this won't be the first mutual fund in India to offer gold as an investment. We already have five gold funds that invest and two equity funds that invest in the stocks of gold mining companies. The gold funds invest in gold itself and they are a good way of investing in gold without having to buy and sell it physically.

Is the new gold-equity hybrid a good idea? Frankly, one doesn't know. It is a new idea so it will no doubt have some marketing buzz but it probably violates a basic principle of hybrid funds. I believe that one side of the hybrid must be an asset type that is much less volatile and much safer than the other. A gold-equity hybrid combines two risky asset-types that can both fall heavily. Frankly, this doesn't fit in with my idea of what a balanced investment should be like.

This may be a hybrid, but it could turn out to be a decidedly unbalanced one.