Conservative Allocation Funds

The SEBI (Securities and Exchange Board of India) has defined conservative hybrid funds as those with 10-25% exposure to equity and equity related instruments and 75-90% to debt instruments.

As per AMFI (Association of Mutual Funds in India), as of July 2023, there are 20 conservative hybrid fund schemes offered by AMCs (Asset Management Companies). The 20 schemes manage around Rs. 25,000 crore worth of investor assets.

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

Low risk

As you may know, debt is considered to be safer than equity (stocks/shares).

Since conservative hybrid funds invest 75-90% of your money in debt instruments and only around 10-25% in equity instruments, the overall risk level stays low.

This means you can invest in conservative hybrid funds without worrying too much about losing your capital or initial investment.

Potentially higher returns than pure debt funds and fixed deposits

The 10-25% equity investment has the potential to deliver higher returns than debt instruments.

If you can stay invested for the long-term in conservative hybrid funds you can expect them to deliver returns that are slightly higher than pure debt funds and fixed deposits.

Note: Equity is a volatile asset and returns cannot be guaranteed. Staying invested in the long term can bring more predictability in equity returns but doesn’t ensure that returns generated will be higher than debt instruments.

Dynamic asset allocation

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

If the fund manager of a conservative hybrid scheme feels that equity is unlikely to perform well in the future, they can reduce the equity allocation to 10%. 

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 25%.

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.

Exposed to many different types of risks

Conservative 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 conservative hybrid fund manager more difficult as he has to navigate several different types of risks.

Returns are low

Conservative hybrid funds invest more than 75% of their assets in debt instruments. 

Debt instruments are income assets whereas equities are growth assets. Simply put, debt instruments help you generate income (in the form of interest) whereas equities help you grow your money through capital appreciation.

So, historically, returns generated by equity have been higher than returns generated by debt instruments.

Long story short: The returns that you can expect from conservative hybrid funds are lower than what you can expect from funds that are more equity oriented.

Note: Expected returns may not match the actual returns. It is possible that debt may deliver higher returns in reality but the expectation is that equity will deliver higher returns over the long term.

Unfavourable taxation

Capital gains tax rate is fixed for equity instruments like stocks and equity oriented mutual funds. Currently 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.

On the other hand, capital gains taxation from debt instruments like debt mutual funds and fixed deposits are taxed at your marginal tax rate. This is also the capital gain taxation applicable to conservative hybrid funds.

If you are in the higher tax brackets (20% and above), then your conservative hybrid funds will be unfavourably taxed.

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. A conservative hybrid fund that targets to maintain 80% allocation to debt and 20% allocation to equity.
2. A mutual fund portfolio that has 80% allocation to debt oriented schemes and 20% allocation to equity oriented schemes.

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

$ Calculated as 80% * 30%* + 20% * 15%

# Calculated as 80% * 30% + 20% * 10%

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

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 conservative hybrid funds:

• New to the financial markets
  If you are looking to dip your feet in the financial markets, conservative hybrid funds can be considered because of their low risk thanks to their debt orientation. As you become comfortable with the volatility of the equity component, you can start exploring more hybrid and equity investments.
• Looking to generate higher returns than debt instruments or fixed deposits
  As we saw, the equity component in conservative hybrid funds can give a potential kicker to the overall returns. However, this kicker in return comes at the cost of equity risks.
• Simplify your portfolio
  Let’s say that the asset allocation that is right for you is 85% debt and 15% equity. Instead of choosing different equity and debt oriented funds to create a portfolio with this asset allocation, you can simply invest in a conservative hybrid fund.

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