Investing is about taking risk and generating returns. Risk persists everywhere
- even in hybrid funds. The extent of risk is different with different investment vehicles. Hybrid funds invest in a combination of asset classes such as equity, debt and gold. The allocation to the different asset classes depends upon the investment objective of the fund.
Since the risk profile of each asset class is different, returns from the scheme will depend upon the allocation to each asset class and the type of securities in each asset class. To simplify, the risk is higher if the equity component is higher. Similarly, the risk is higher if the debt component is invested in longer term debt securities or lower rated instruments. Hybrid funds invest in a mix of debt and equity. It is rare for both debt and equity markets to fare poorly at the same time. Since the performance of the scheme is linked to the performance of these two distinct asset classes, the risk in the scheme is reduced through diversification across asset classes. This makes hybrid funds a bit riskier than debt mutual funds but less risky than equity funds.
Apart from the above, there are generic risks pertaining to hybrid funds. Some of them are inflation, default risk, liquidity risk and reinvestment risk. While we have discussed the above in our blog on understanding risk, here we would be focusing on risks pertaining to the different hybrid mutual funds schemes.
Risks Pertaining To Hybrid Schemes
Monthly income plan (MIP) is a hybrid fund that seeks to combine a large debt portfolio with a yield and some alpha returns to be generated in the form of an equity component. In such a structure, it is possible that losses in the equity component eat into the profits in the debt component of the portfolio. Remember that it is not necessary that as the name suggests the scheme should compulsorily announce a monthly dividend. If the scheme has no profits to distribute, then no dividend will be declared. Thus, the investor may not get the monthly income implicit in the name MIP. That’s why understanding the portfolio construction is important. While the fund managers know their forte, it is the financial goals and risk capacity of the investor that matters most here. We would advise looking at the scheme portfolio first before investing in an MIP.
Arbitrage funds are specialised funds which operate by simultaneous buying and selling of securities in different markets to take advantage of the price difference. Arbitrage opportunities also arise by trading in futures and options (F&O) segments. This fund works for the benefit of investors, in situations of volatility. In reality, the risks are arbitraged between the cash market and the F&O market. Therefore, the risk in this category of funds turns out to be relatively low compared to equity funds. However, one should not forget the risk in an arbitrage fund, the risk that both cash and F&O positions on a company cannot be reversed at the same time. During the time gap between unwinding of the two positions, the market can move adverse to the scheme.
Further, the returns here are sometimes lower, more in-line with money market returns, rather than equity market returns. There are other risks as well. While the fund managers may take exposure expecting markets to remain volatile and markets remain stable, the returns would be much lower here. In other words, the mediocre reliability in terms of returns becomes a major risk.
Flexible asset allocation, as the name suggests, offers significant asset allocation flexibility to the fund manager. Subject to maximum limits approved by Securities and Exchange Board of India (SEBI), here fund managers have an advantage that depending upon their view and expectation from the markets (debt and equity) they can switch a large part of their portfolio between debt and equity. This kind of scheme is called a flexible asset allocation scheme. This would be a major cause of risk for investors, because there is possibility that the fund manager takes a wrong asset allocation call. As stated earlier, timing the market is almost impossible and sometimes even the expert fund managers may take a wrong call. If someone wants to take advantage of such active allocation between debt and equity, it is advisable to opt for fixed asset allocation funds.
Risk in gold funds. When financial markets are in turmoil, gold does well. It is one precious metal that derives its price from the global demand and supply factors. Similarly, in case of geopolitical risks like war or other issues if a currency weakens, gold funds generate excellent returns. These twin benefits make gold a very attractive risk proposition. However, one must be sure about what kind of gold fund it is — is it a gold sector fund or a gold ETF?
Risk in real estate funds. Real estate has always been considered as a physical asset and not a financial one. A few years back, the realty segment did not have any regulator. It was considered as a risky asset class. Real estate is a comparatively less liquid asset class. The intermediation chain of real estate agents is largely unorganised in India. Transaction costs, in the form of stamp duty, registration fees, etc. are high. So, in case of physical assets the risks were higher. However, things are changing slowly and regulatory risk has reduced to certain extent. However, despite becoming a financial asset, real estate funds are still quite high in risk compared to other mutual funds scheme types. However, with regulation in the mutual funds, it is true that the real estate mutual funds schemes are less risky than direct investment in real estate.
