What is the difference between hybrid funds and debt funds?

Mutual Funds have taken the Indian markets by a huge storm. As per AMFI reports for the year 2019-20, 9.83 lakh SIP accounts have been added each month! Broadly speaking, there are five categories of mutual funds for Indian investors:

• Equity schemes, 
• Debt schemes, 
• Hybrid schemes, 
• solution oriented schemes, and
• other schemes such as ETFs, FOFs, etc.

In this article, we will compare hybrid funds and debt funds and see if one of them has an edge over the other. But before we determine if you should invest in hybrid funds or debt funds, let us look at their meaning.

Debt Funds are mutual funds which invest predominantly in debt and money market instruments. As these schemes allocate a majority of their total assets in fixed-income or interest generating instruments, they are considered a relatively low-risk investment option. Debt funds seek to generate average (but stable) income for the investors. 

Hybrid Funds are mutual funds that vest across asset categories (for instance, equity, debt, arbitrage positions, etc.). The core benefits of hybrid funds are that they seek to combine the best of both worlds – higher capital appreciation from equity exposure as well as stability through the presence of debt. They are also referred as Balanced or Asset Allocation Funds.

Comparison of Hybrid and Debt Funds

1. Portfolio Composition

The portfolio of debt funds consists predominantly of debt and money market instruments. The benefits of Hybrid funds, on the other hand, is that they come in all shapes and sizes. For instance, aggressive hybrid funds have a higher equity exposure and a small debt allocation. Conservative hybrid funds have a significant debt presence and marginal equity exposure. As a result, regardless of your risk appetite, there will be a hybrid fund which is aligned to your investment profile.

2. Risk

Debt funds have a low-risk profile when compared to equity funds. However, contrary to popular opinion they are not completely risk-less investments. They have three risk agents – credit risk, interest rate risk and liquidity risk. Usually, longer is the maturity period of the debt funds’ underlying instruments, higher is their risk quotient.

The risk profile of hybrid funds is derived basis its asset allocation. Schemes with significant equity exposure (such as aggressive hybrid funds) have a higher degree of risk. Schemes with majority allocation in debt instruments (such as conservative hybrid) have a lower risk quotient.

3. Returns

Higher the risk, higher is the return. As a result, debt funds which carry relatively less risk yield low returns. However, they are usually stable in nature. 

Hybrid Funds, on the other hand, have the potential to generate higher returns by increasing their exposure.

4. Liquidity

Debt Funds (especially Liquid or Overnight schemes) score over Hybrid Funds in this aspect. These funds are extremely liquid in nature. Some even have the provision of instant redemption. Hybrid Funds take longer to liquidate because of the presence of equity in their asset allocation.

5. Taxation

Income Tax framework considers only two categories of mutual funds – Equity Funds or Debt Funds. Gains from Debt Funds are treated as long-term capital gains if the holding period exceeds three years. They are taxed at 20% with the benefit of indexation. Short-term capital gains from these schemes are taxed as per the applicable income tax slab (As part of your overall income).

When it comes to hybrid funds, the taxation guidelines are dependent on their asset allocation. If the scheme invests more than 65% of the total assets in equity (or related instruments), it is taxed as an equity fund. Otherwise, the tax rules for debt funds are levied.

6. Investment Horizon

Debt Funds are a good option for short-term financial needs. Hybrid Funds are more suited for investors with a medium – long term investment horizon. This is because, equity markets are extremely volatile, especially in the long run. You need to remain invested for a significant time period (at least a full-term government) to get the maximum return on your equity investment.

Final Words

So, should you invest in hybrid funds or are debt funds? Unfortunately, there is no one answer that will apply to all investors. Active risk management, diversification and auto portfolio rebalancing are some of the key benefits of hybrid funds. On the other hand, debt mutual funds are less volatile, safer and financially more lucrative than conventional instruments such as FDs. 

The final decision (whether you invest in hybrid funds or debt, or in fact any financial instrument) your own investment profile – risk appetite, financial goal as well as investment duration. Even the best performing mutual fund may not generate the desired results for you if there is a mismatch between the scheme’s objective and your investment profile. So, align yourself and rake in the moolah!