Aggressive Allocation Funds

The SEBI (Securities and Exchange Board of India) has defined aggressive hybrid funds as those with 65-80% exposure to equity and equity related instruments and 20-35% to debt instruments.

As per AMFI (Association of Mutual Funds in India), as of July 2023, there are 30 aggressive hybrid fund schemes offered by AMCs (Asset Management Companies). The 30 schemes manage around Rs. 1,70,000 crore worth of investor assets.

Aggressive hybrid funds can have several benefits depending on your use case. Here are some of the major benefits:

Dynamic asset allocation

Different macroeconomic situations help different asset classes (like equity and debt) perform better/worse. 

If the fund manager of an aggressive hybrid scheme feels that equity is unlikely to perform well in the future, they can reduce the equity allocation to 65%. 

On the other hand, if they feel that equity is likely to generate good returns in the future, they can increase the equity allocation to 80%.

This flexibility gives the fund manager a role to play in the asset allocation which, if they get right, can result in higher returns for you.

Debt provides cushion during volatile times

The 20-35% debt allocation in aggressive hybrid funds helps them survive market volatility and crashes.

Suppose there’s a pure equity fund (PEF) with 100% allocation to a portfolio of stocks. There are two aggressive hybrid funds (AHF-1, AHF-2) with 80% and 65% allocation to the same portfolio of stocks and the remaining 20% and 35% allocation to a portfolio of debt securities.

Let’s assume that you have invested Rs. 1,00,000 in each of the 3 funds described above.

If the portfolio of stocks experiences a 50% crash due to a macroeconomic event, here is what will happen to your investments in the 3 funds:

As you can see, the debt component (assumed to have experienced neither gain nor loss during the equity market crash) in the aggressive hybrid funds help reduce your notional loss.

Favourable taxation for the debt component

The capital gains tax rate is fixed for equity instruments like stocks and equity oriented mutual funds. 

It is 15% for gains booked within 1 year of investing, also known as short-term gains; 10% for gains booked after 1 year of investing, also known as long-term capital gains. This also the capital gain taxation applicable to aggressive hybrid funds since they are equity oriented mutual funds.

On the other hand, capital gains taxation from debt instruments like debt mutual funds and fixed deposits are taxed at your marginal tax rate.

If you are in the higher tax brackets (20% and above), then your aggressive hybrid funds will be taxed at the equity taxation. This works in your favour because the debt component (25-40%) would have attracted a higher taxation rate had you invested in it directly or through some debt mutual fund scheme(s).

Illustration:

Let’s assume that you are in the 30% tax bracket (let’s ignore cess, surcharge etc. for simplicity’s sake). You have two investment options: 

1. An aggressive hybrid fund that targets to maintain 70% allocation to equity and 30% allocation to debt.
2. A mutual fund portfolio that has 70% allocation to debt oriented schemes and 30% allocation to equity oriented schemes.

Here are how you will be taxed for in each case:

$ Calculated as 70% * 15% + 30% * 30%

# Calculated as 70% * 10% + 30% * 30%

The taxation is even more favourable for aggressive hybrid funds when we consider that capital gains of Rs. 1 Lakh per financial year for periods >1 year is exempt from tax.

Exposed to many different types of risks

Aggressive hybrid funds take exposure to equity as well as debt instruments. Both the instruments are exposed to different types of risks.

Equities are exposed to market risk, currency risk, commodity risk etc. Debt instruments, on the other hand, are exposed to credit default risk, interest rate risk, liquidity risk etc.

Pure equity or pure debt funds would have been exposed to just one set of risks but hybrid funds are exposed to 2 sets of risks.

This makes the job of the aggressive hybrid fund manager more difficult as he has to navigate several different types of risks.

Not very affordable

Most aggressive hybrid funds are a mix of large cap funds and corporate bond funds. But the expense ratio of aggressive hybrid funds is higher than a portfolio mix of large cap and corporate bond funds.

To be able to make a comparison, let’s assume that aggressive hybrid funds target to have a 70% equity and 30% debt allocations at all times. We can compare this with mutual fund portfolios that can be as close to an aggressive hybrid fund as possible.

%Direct plans of all active open-ended schemes considered as of Aug 2023

#Assumed average expense ratio of large cap index funds is 0.3%

Dezerv internal research

As you can see, aggressive hybrid funds have a considerably higher average expense ratio than a mix of 70% equity funds and 30% corporate bond funds.

Well, it depends. The best person to answer this question is a financial advisor who has spent time understanding your financial goals and risk profile.

However, here are some situations where you can consider aggressive hybrid funds:

• Use asset allocation to generate alpha
  It is popularly believed (and proven by many studies) that asset allocation is the biggest determinant of your investment returns. Aggressive hybrid funds can play on asset allocation and generate higher returns to you by adjusting equity/debt allocations.
• Simplify your portfolio
  Let’s say that the asset allocation that is right for you is 75% debt and 25% equity. Instead of choosing different equity and debt oriented funds to create a portfolio with this asset allocation, you can simply invest in an aggressive hybrid fund.

Note: The above information is for educational purposes only. It is best to consult a financial advisor before making investment decisions.