What are Hybrid and Balanced Mutual Funds? Why doesn't Goalwise recommend them?


Many of us are familiar with Equity Mutual Funds that invest in stock markets and Debt Mutual Funds that invest in bonds.

Although not as popular, there are some more types of Mutual Funds also:

Hybrid Mutual Funds, as the name suggests, invest in both stocks and bonds. The split between stocks and bonds is decided by the fund manager according to some broad guidelines set out in the Mutual Fund's prospectus.

Balanced Mutual Funds are a type of Hybrid Mutual Funds i.e. they also invest in both stocks and bonds with the extra condition that they will have at least 65% allocated to stocks. This allows them to be taxed like Equity Mutual Funds (tax-free after a year) whereas other Hybrid Mutual Funds that hold less than 65% equity are taxed like Debt Mutual Funds (never tax-free).

At Goalwise, we don't recommend Hybrid Mutual Funds (or Balanced Mutual Funds) for two reasons:

  1. Lack of control over asset allocation - The asset allocation i.e. the split between stocks and bond is not under your control. It is decided by the fund manager and everyone gets the same allocation which may not be as per your goals or risk profile. Keeping them separate allows us to customise the asset allocation according to your needs.

    For e.g. Balanced funds will always have at least 65% equity by regulation, even if the fund manager thinks that the markets are super risky.

  2. Lower returns - Instead of choosing the best Equity Funds and the best Debt Funds separately, we will be forced to choose from a limited menu of Hybrid Funds.

    This can negatively impact our returns as it is very unlikely that a fund manager would be great at stock picking, bonds picking and also managing asset allocation (how much equity vs how much debt).

It is like choosing a jack-of-all-trades when you can have the masters of each.

What about the tax advantage on the debt part of Balanced funds?

A lot of people believe that investing in Balanced Mutual Funds instead of a combination of best Equity and best Debt funds is better because the debt part of Balanced Mutual Funds gets taxed like equity (15% STCG and 0% LTCG).

Some quick back of the envelope calculation shows this to be penny-wise and pound-foolish thinking.

Let's see how much tax do you actually save on the debt part.

Max Debt allocation % = 35%
Average debt returns % = 7%

Returns from debt part in a year = 35% * 7% = 2.45%

Max tax on debt returns assuming highest tax bracket of 30% = 2.45% * 30% = 0.735%

So in a year this is the max amount you are saving on taxes by investing in balanced funds.

Now, if the equity part of your balanced fund underperforms the best Equity funds by even 1%, almost all the tax advantage is gone!

If it underperforms by 2-3%, which is quite likely given the wide dispersion between returns of equity funds, you are already losing more in returns than you are saving in taxes.

Giving up returns to pay lower taxes does not make sense. Don't miss the forest for the trees.

With sophisticated investing platforms like Goalwise which automatically select the best Equity and Debt Mutual Funds for you according to your goals and risk profile even laziness cannot be a reason to select a Hybrid Mutual Fund anymore. :)