Ahybrid fund is a type of mutual fund or exchange-traded fund (ETFs) that involves investing in multiple asset classes. Unlike an equity fund of a bond fund that focuses on investing only in equities or bonds, a hybrid fund usually has a mix of equities, debt securities, or cash and equivalents.
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How Hybrid Funds Work
A hybrid fund serves as a stand-alone investment option by having different combinations of securities within the same fund. This could be a combination of both stocks and bonds, with the percentage of allocation in the asset classes being constant or varying.
As such, hybrid funds comprise a diversified portfolio that arises from investing in many asset classes.
Learn more in a related article: Portfolio Diversification And How to Achieve It
Hybrid funds are characterized by a given objective depending on the type of growth and risk level. The objective varies from conservative, moderate and aggressive. The objective is what also determines the asset allocation of one’s portfolio in a hybrid fund.
Asset allocation refers to the distribution of funds among different asset classes. Thus, if the objective is conservative, the percentage of funds invested in bonds is more than that invested in stocks, given that debt constitutes a lower risk.
Correlation also plays an important role in hybrid funds as it looks at the movements of the assets’ returns. Securities within the same asset class have a higher correlation, whereas a combination among different asset classes exhibits a low correlation.
Hybrid funds work by investing in assets with a low correlation, which helps lower the risk of the portfolio.
Types of Hybrid Funds
Balanced Hybrid funds
Balanced Hybrid funds involve constant asset allocation over a given period. Generally, there are three types of balanced:
1. Conservative / Debt Oriented
The funds are oriented towards less risk and slow growth. They are considered investments that are safer with the returns and risk not varying greatly. This type of funds involves more allocation in bonds and a lesser percentage in stocks. Such a fund will primarily have 60 % of funds invested towards bonds and 40% towards stocks.
2. Moderate Funds
This category comprises of investing in assets that have medium risk exposure. The objective for this is also medium growth, with good returns without taking high risks. Such an allocation might constitute 30% of funds towards bonds, 65% of funds towards stocks, and 5% in cash and equivalents.
3. Aggressive / Equity Oriented
Aggressive funds look at investments that offer high returns and are highly risky. The growth potential is huge and constitutes a greater proportion of its assets in stocks. An investor who has an aggressive portfolio has a high ability and willingness to take risks. An aggressive portfolio is also ideal for an investor with a long time horizon, usually more than 10 years. An example of this is a portfolio with 85% of its investments in stocks and 15% in debt securities.
Target Date Funds
This type of hybrid fund rebalances the portfolio within a given date. As such, asset allocation is not fixed and tends to change as the timeline changes.
With the investment objective in mind, an investor chooses the target year, and as the target date approaches, the asset allocation takes on less risky investments. For instance, if the objective is retirement, the year of retirement is set as the target date.
A target fund will mostly have a greater allocation in stocks at the beginning of the investment. This provides higher returns and growth during the fund’s first years. The allocation then changes progressively from aggressive to conservative investments in a bid to minimize losses.
Who Should Invest in a Hybrid Fund?
Hybrid Funds are considered a means to an end and are usually suitable investment vehicles for some of the below investors.
With no regular income, hybrid funds are a lucrative option for retirees to have income on a steady basis. The conservative hybrid funds are more appealing for these investors as the larger proportion of funds lies in debt, making it less risky to lose their funds.
2. Investors with an aim for asset allocation
Many investors look at hybrid funds as a diversified portfolio. The fund consists of different types of asset classes, which have lower correlations with each other. As an investor, you can allocate assets based on your willingness and ability to take risks and your investment horizon.
3. Investors with a medium-term goal
Hybrid funds are an excellent option for investors looking at an investment horizon of 3-5 years. Moderate funds combine both high-risk and low-risk asset classes, which offers reduced exposure to risks.
4. First Time Investors of Mutual Funds
First-time investors are generally more risk-averse but also look to increase returns of their funds through mutual funds. Hybrid mutual funds offer this scalability by providing asset classes with various risk levels and returns congruent to the investor’s investment objective.
What to consider before investing in Hybrid Funds
The exposure in Hybrid funds will depend on the percentage allocated to stocks. The fund is mostly riskier if the highest allocation is on stocks. The conservative option is geared towards interest-bearing debt instruments.
The returns vary in a hybrid fund vary since it is solely dependent on the securities allocation. A conservative balanced hybrid fund will have its returns based mostly on the interest borne from the underlying debt instruments while aggressive funds peg their returns from the stock performance.
3. Investment horizon
Long investment horizons are suitable for stable returns with the compounding element of funds being considered. For hybrid funds, a medium to long term horizon is more appropriate.
4. Financial goals
Having a solid goal of investments enables investors to choose a scheme that is congruent to their goals. An investor about to retire can choose the target date hybrid fund to achieve his financial goal.
Pertinent to mutual funds, costs are a vital factor that hybrid fund investors should consider. Generally, low fees will have less impact on hybrid fund returns.
6. Investment Strategy
Fund managers already predetermine the investment strategy. As such, investors should look at asset locations and base their decisions on this.
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Advantages of Hybrid Funds
- Diversification- hybrid funds enable the allocation of funds in more than one asset class. This reduces the risk of the portfolio and enhances returns.
- Portfolio rebalancing- Fund managers actively manage portfolios and rebalance asset allocation based on market movements to the investor’s advantage.
- Stand-alone investment option- hybrid funds act as a single-vehicle with various asset classes therein. Investors can thus invest in a single product while taking advantage of multiple asset classes.
- Oriented towards risk profiles- hybrid funds offer a wide risk profile that caters to all investors. Investors can choose from conservative, aggressive, and medium hybrid funds based on their risk profile.
- Increased Returns- Rebalancing portfolios within different asset classes ensures the generation of substantial returns. This is from the purchase and sale of various securities within the asset classes.
Disadvantages of Hybrid Funds
- High Costs – hybrid funds, just like mutual funds, have expenses in the form of fees to manage the funds. Such fees are a crucial component while making investment decisions.
- Minimal Authority on Decision Making – investment firms usually have a predetermined hybrid fund, together with the investment strategy. The decision majorly lies in professional fund managers and not investors.
- Risk Component – hybrid funds are not without risk. Exposure to the stock market bears the risk element that has an impact on funds.