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Aggressive hybrid vs balanced advantage funds: Which one to choose?

Here we tell you what aggressive hybrid and balanced advantage funds are and which should be preferred

Aggressive hybrid vs balanced advantage funds: Which one to choose?

What is better - aggressive hybrid funds or balanced advantage funds? - Amit Singhal

Mutual funds can be broadly classified into three categories.

  • Pure equity funds that invest predominantly in equity stocks across different market capitalisations.
  • Debt funds that invest in fixed-income securities.
  • Hybrid funds that invest in both debt and equity instruments.

Hybrid mutual fund schemes combine equity and debt investments in a certain ratio to achieve diversification and avoid concentration risk. A perfect blend of the two offers higher returns than a regular debt fund while not being as risky as equity funds. There are six types of hybrid funds and the choice depends on your risk preferences and investment objective.

Here we will focus on two specific types: aggressive hybrid funds and balanced advantage funds.

What are aggressive hybrid funds?
Aggressive hybrid funds are mandated to invest up to 75 per cent of their assets in equity and the remaining in fixed-income instruments. Other than the usual mixture of debt and equity, these funds take advantage of an arbitrage opportunity. In arbitrage, the fund manager buys securities at a low price in one stock exchange and sells them at a higher price in the other. Hence, the gains are accrued as a result of the price differential.

The equity portion helps in the growth of the fund and the debt portion works as a cushion for the portfolio to contain the downside of the market. This provides psychological comfort to investors who have just embarked on their investment journey. This asset combination is much better as compared to pure equity funds making this category an ideal investment option for first-time investors who are not familiar with the volatility of the equity markets.

What are balanced advantage funds?
Balanced advantage funds are schemes with a dynamic asset allocation strategy and they too invest in a mix of equity and debt. The fund dynamically manages allocation between the two, which is usually driven by a philosophy or a methodology developed by the fund house.

With an inbuilt rebalancing strategy, these funds sell stocks in their portfolio when valuations are high and invest them in debt, and do the opposite when markets crash. This dynamic allocation allows investors to 'capture the potential upside and limit the downside in volatile equity markets'. Such a quick, effective, and conservative investment strategy helps the investor handle the market volatility quite comfortably. Thus, investors get the optimum benefits of both asset classes - debt and equity.

What's the difference between aggressive hybrid and balanced advantage funds?
The essential difference between a balanced advantage and an aggressive hybrid fund is asset allocation. In an aggressive hybrid fund, the equity allocation is between 65 to 80 per cent and the rest in fixed income.

However, the asset allocation is dynamic in the balanced advantage fund. The fund can be fully allocated to equity or debt instruments depending on the fund manager's view of the market. Certain funds have a formula-driven approach that takes market valuations and other factors into consideration. The allocation is pre-decided based on the formula that defines the equity exposure based on the different variables. While in some funds, the manager takes a call and actively changes the allocation.

When it comes to taxation, aggressive hybrid and most of the balanced advantage funds are termed equity-oriented funds. So they are taxed the same and it depends on the investment horizon. The gains on funds held for less than 12 months are termed short-term capital gains and are taxed at 15 per cent. For holdings beyond 12 months, the gains are termed long-term capital gains and are taxed at 10 per cent with an exemption up to Rs 1 lakh.

Both sound good to the investor but which one to choose?
Aggressive hybrid funds, and here's why.

On paper, the investment mandate of dynamic asset allocation funds looks very promising. They are the most unconstrained type of mutual funds available. Here, fund managers have complete flexibility to invest across equity and debt instruments in any proportion and then dynamically alter the mix of debt and equity, depending on their market outlook or several other factors that they may want to take into consideration.

Despite this unconstrained investment mandate, we are wary of this category because to be able to dynamically move between equity and debt often requires the fund management team to take a call on the markets. It's fairly difficult to take the right call on the market consistently for the long term and our analysis proves that.

But as an investor, you need to take a closer look at the asset allocation strategy of such funds. If the fund chooses to continue with the investment strategy as before, you need not worry. But if there is a change in investment attributes, you might have to rethink. The change can also negate all the past performance, making them redundant.

On the contrary, we are much more comfortable with aggressive hybrid funds, which have a more defined asset allocation pattern. For instance, aggressive hybrids come with a much-defined asset allocation of about 75 per cent equity and 25 per cent debt, rebalancing periodically to remain close to this kind of allocation. The advantage of this is

  • First, the fund manager does not need to take a call on the market. There is a defined asset allocation around which the actual allocations can revolve.
  • Second, from an investor's perspective, it provides a very definitive cue about where the fund lies on the risk-return spectrum.

Therefore, investors can decide whether or not a particular hybrid fund is suitable for them, depending on their investment time horizon, goals, and if that kind of asset allocation suits their investment needs. This will make it easier to fit these funds seamlessly into your financial plans.

Thus, we believe that hybrids that come with a more defined asset allocation should be preferred.

Read our series on balanced advantage funds.

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