The Mutual Fund Show: The Pros And Cons Of Conservative Hybrid Funds
Conservative hybrid funds allocate 75-90% to debt and the rest to equity.
Conservative hybrid funds allocate 75-90% to debt and the rest to equity. These schemes are ideally suited for an investment horizon of three to five years.
While such funds are said to be for moderate-risk investors, it is not technically a conservative product, Rushabh Desai, founder of Rupee With Rushabh Investment Services, told BloombergQuint's Niraj Shah.
“This particular category is poor in risk mitigation because there are two different asset classes—debt and equity—in one product," he said. If one segment or both the segments are not doing well, the investor is stuck.”
While such funds can be dynamic, Desai’s assessment of existing products is that they are static in nature and compromise on returns compared to other multi-asset category funds. Other disadvantages are the credit risk on the debt side and a high expense ratio, he said. Desai advises investors to skip such funds and to keep their equity and debt portfolios separate.
But according to George Heber Joseph, chief executive officer and chief investment officer of ITI Mutual Fund, there is space in this category for a product that can mitigate these concerns.
Joseph said ITI MF’s new fund offer has a low expense ratio and manages the liquidity risk through exposure to safe, liquid investments. “Even if the returns are not very high, the product can be an alternative for people who have their money in a fixed deposit and other savings products which yield a very low rate of interest,” he said.
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Here are the edited excerpts from the interview:
George, what is the conservative hybrid category? Is it timely because 2022 promises to be a year of volatility and therefore, it pays to be conservative?
George H Joseph: The conservative hybrid category is a very interesting category where a lot of assets under management has not flown in yet. When we look at that category, it has two parts – one on the taxation front and how it is benefiting investors. Secondly, as a product, how less volatile that category is. So that's what attracted us. We have a lot of mutual fund distributors as well as registered investment advisors suggesting that we look at this category and come up with an innovative product. We have worked on the product and the category is looking similar to an asset allocation basket between equity and debt.
It is a very conservative category, and at the same time, for a stable and steady return generating product profile, it suits investors who are actually invested in traditional savings products. It is a category for investors to look at when you're looking from a mutual fund perspective for a switch category from a traditional savings investment product.
This category is about 75% or slightly over that in debt, slightly below 25% and it could go up to over 10% in equity. Rushabh, are there some things to keep in mind for an investor when they are looking to invest in the conservative hybrid category?
Rushabh Desai: I am not a big fan of this category. This particular category is very poor in risk mitigation because there are two asset classes – debt and equity – both in one product. Debt and equity work in different ways. So, if one segment is not doing good, or if both the segments are not doing good, the client or investor is stuck in this particular product.
Theoretically, this is meant for moderate risk investors, but technically this is not a conservative product. The risk profile of the fund depends on various factors like the credit profile in the debt segment, the maturity profile within the debt segment, and how liquid are the instruments within this particular fund.
Coming to the equity side, it depends on how aggressive the fund manager is in terms of style, in terms of strategy, whether the fund is more inclined in terms of large cap or mid cap or small cap or a combination of all three.
So, this is not a conservative product and it's better for investors having the 75-25% kind of allocation to keep the debt portfolio and equity portfolio separate, from a risk management point of view.
The same risks would be applicable to almost any hybrid fund which dabbles between debt, equity and, in some cases, they also have other asset classes. Multi-asset funds or any other funds would also be a no-no, if that's the parameter?
Rushabh Desai: Aggressive hybrid products have a static kind of allocation. Conservative hybrid funds are static allocation, they're not very dynamic in nature.
Balanced advantage funds and dynamic asset allocation funds are the exception because the fund manager is actively taking calls on a regular basis. So, where there is static allocation, it's better to keep your portfolios separate.
People choose multi asset funds or balance advantage fund because they trust the fund manager with the ability to time the cycles – both on the debt and equity side – which they cannot. They get the best of both worlds with a single investment. The idea is that conservative hybrid funds are not very aggressive or active and are more static in nature, and the investor should separate the portfolios. George, how will you respond to that?
George H Joseph: We have addressed all these points. The product is a clear winner because the fund manager has the option to choose what kind of equity he wants in the 10-25% equity level, and you can have a dynamic asset allocation strategy between 10-25% as well. Secondly, within debt, the fund manager also has the option to decide on the maturity profile or credit profile.
Typically, an investor may not know where to invest in debt. The interest rate scenarios or business cycle scenarios are difficult to predict. The economic or macroeconomic fundamentals are changing day by day. It has been difficult for an individual investor to understand and dabble with it. Allocating to debt or equity is a complex subject. It is easily available in any of the hybrid category products.
Static allocation is in the hands of the fund manager as well in terms of how static you want to be. You can have a passive strategy to keep the volatility low on the equity side and be active on the debt side or vice versa.
So, we realise that there's a category not addressed sensibly and there is a possibility of looking at it in a different way rather than what has been historically or traditionally followed within the mutual fund space.
So, there is an opportunity to look at it from a traditional savings product aspect where inflation is at 6% and FD interest rate is 5%. Your real return is -1%. Can we have a solution? Ideally, a mutual fund manufacturer of a product of hybrid or dynamic asset allocation category should be thinking of this. There is an opportunity there for an investor to look at this category and invest and sensibly generate reasonably long-term good Alpha over traditional savings instruments.
George, are you trying to say that the category itself is suitable largely for people who have not been exposed to the mutual fund side at all? They've been using traditional savings products, and therefore, as the first step, since you need conservative returns and to test the waters, they can get into conservative hybrid funds. What about people who are already in the mutual fund space and have exposure to various mutual fund products?
George H Joseph: It is applicable for both – it depends on the risk appetite. I have come across clients who have already made money and who are investors in mutual funds; they want a steady 6-7% returns consistently generated. They have a basic requirement: they don't want to reduce the money they have already generated and want to beat the inflation and generate decent returns.
In mutual funds, not all products are risky. There are very low-risk products and high-risk products. Within debt as well, you have low-risk to high-risk products depending upon the maturity profile of the products defined by SEBI.
So this comes under the moderately high risk as per the definition. But in the way you run, you can make it much more pleasant for the investor. There is a clear opportunity for people invested in fixed deposits to venture out and move to mutual funds. There is a clear avenue that has opened up through these products.
What are the expense ratios and what about the taxation structure? Are there other products or categories which may offer similar returns but better taxation and therefore, the post-tax returns could be almost equal or better or worse?
George H Joseph: Taxation is nicely defined if indexation is possible, if you hold it for three years. Roughly, there is 22% taxation in the conservative hybrid category. If you look at the traditional savings instruments, say fixed deposits, taxation is between 33% to 40%. So, it is a clear winner for an investor who is already in the mutual fund space or otherwise looking at creating a long-term investing approach if you're not very aggressive in your investment style.
For the last couple of months, I've heard people talk about how even if you want exposure to debt products, you could look at arbitrage funds or some other products where the taxation is a bit friendlier. Rushabh, could you tell us about the expense ratios and taxation aspect?
Rushabh Desai: In terms of taxation, it's better to know that debt is always meant for capital protection, it is not meant for wealth creation. You cannot think of generating slightly higher returns because, at times, debt can be riskier than equities.
When a default or downgrade happens, when your money is lost, it's completely lost. If you're invested in equities, you still have the chance that over a longer period, you can recover and generate money. So, in terms of taxation also, keep it simple and keep things separate. Debt is meant for capital protection; equity is meant for wealth creation.
Within this category, historically as well, the average expense ratio has been 1.9%. So, it is much higher than many of the active and passive equity funds, and pure equity funds as well.
It kind of eats your real returns in the long term when you have a high expense ratio. Historically, more than 50% of these schemes have taken credit risk in some form or the other. I'm not talking about small credit risks; they have taken high credit risks. So, that puts your product and yourself into a very high-risk bracket.
But that's also true for most debt funds, not just conservative hybrid funds?
Rushabh Desai: Yes, but you can easily track and see many of the products have strict mandates. They will follow a AAA kind of thing, or the average maturity would be in a certain fashion. So, it’s much easier to monitor and track.
In difficult times, it's much easier to get out of these products. But when you're coming into a mix-and-match kind of product which has static allocation it's difficult in times of uncertainty to get out of the product.
George says that some hybrid conservative funds can actually be a bit more dynamic. Are you waiting for evidence on that from the existing products?
Rushabh Desai: Absolutely. That is what historical data has shown. For example, in today's fixed income scenario, when the Fed is going to hike rates, and the Reserve Bank of India is also planning to start, it's better to be on the shorter end than on the longer end.
But there are many products – conservative or hybrid funds – which have an average maturity of 8 or 8.5 years which is very high. Every market situation demands a different kind of strategising, a different kind of planning. From an overall perspective, it's kind of a rigid product.
While the category may have had some issues, there is room for a good product which can tackle some of the shortcomings. George, tell us about the product that you are coming out with and how is it different from existing conservative hybrid funds?
George H Joseph: We saw that the category average expense ratio is very high, so we have kept the expense ratio very low: – 1% is the expense ratio. This is at the time of NFO and post-NFO, we are inkling towards reducing the expense ratio to 16 pips (percentage in points). It will be a clear winner from the expense ratio point of view within the category.
Secondly, the maturity profile of many debt instruments within the category has been very high. We want to bring liquidity in the portfolio, so that investors should be comfortable putting in money at any point in time. And if you want to pull out, you should be able to do it.
On the debt side, we will have a dynamic debt allocation mix and the modified duration will be less than five years.
If you look at the portfolio, 70-80% will be in G-Sec (government securities) of different maturities, and 20% will be in PSU bonds, which is AAA bonds. The quality of the portfolio will be very high.
Now, coming to the sovereign rating, there is no liquidity risk. You can sell on any day without any impact costs. That's how we are running our dynamic bond portfolio. We are more or less mimicking the dynamic bond portfolio.
On the equity side, 10-25% is the leeway which SEBI provides in this category. Instead of going for arbitrage opportunities – which is another way to run a regular savings product – because arbitrage rates can crash to less than 3% or below rates, we are moving to the equity level to 10-25%. We are running the dynamic bond – the balance advantage one for ITI Mutual Fund, in a similar fashion.
A dynamic asset allocation product like the balanced advantage fund is doing reasonably well. In a similar way, we will be moving 10-25% equity allocation in this conservative hybrid fund as well depending upon the asset allocation needs we will have.
We are going to invest only in Nifty 50 stocks or probably in the index itself, so that you're mimicking the passive strategy in terms of stock selection. Active dynamic asset allocation is between 10-25% on the equity side. For debt, we will be following an active strategy keeping in mind the liquidity profile.