In times when volatility is the mark across asset classes, be it equity, debt or gold, where do you invest? Asset allocation can be an answer to that and asset allocation funds can be of help.

Graphics by Yogesh Kumar/Mint

Also See | At a Glance (PDF)

Domestic equity markets have lost at least 22% year-to-date (YTD), bond prices have been volatile in the second half of the calendar year, whereas interest rates have remained high through most of the year. Gold has been a big outperformer across asset classes, delivering at least 40% since the start of this year. While the popularity of gold as an investment option is on the rise (domestic gold exchange-traded funds, or ETFs, garnered close to 3,500 crore YTD till 30 September), it’s impossible to tell how long the rally will last, especially given the sharp rise this year (prices have seen sharp correction in this week itself). For that matter, it is anyone’s guess when the equity markets may revive. Also, interest rates are not expected to remain high for much longer.

Hybrid funds take into consideration this uncertainty in returns across asset classes and aim to deliver efficient risk-adjusted returns with the help of diversification.

How do they work?

Diversification helps manage risk… In volatile markets, these funds have helped in protecting the downside (see graph). Says Lalit Nambiar, fund manager and head (research), UTI Asset Management Co. Ltd, “There is no certainty where returns may come from. In this environment managing risk is more important, which means protecting the downside. And to cover risk, it is a good idea to diversify across asset classes."

Nambiar explains, “It (hybrid funds) allows us to invest in a neutral asset while equities are not performing well and as and when market sentiment improves we can increase equity allocation." UTI Wealth Builder II did not always have a high allocation to gold and has done that now as the fund manager’s outlook is positive.

During a rally, chances are that an equity-oriented hybrid fund, owing to its exposure to other assets, may underperform pure diversified equity funds, but there will be reasonable participation in the upside (subject to the fund manager’s performance).

…And give returns a boost: In case of funds that are largely debt-oriented, the equity portion is meant to add returns, whereas gold works as insurance without significantly altering the risk profile. Despite some amount of equity exposure, fund returns are not only positive in six and 12 months but have also outperformed MIP returns in the same periods (see graph).

Also See | Category Performance (PDF)

Equity exposure in some of these funds will add positively to the returns when equity markets start to perform better. Says Akshay Gupta, managing director and chief executive officer, Peerless Funds Management Co. Ltd, “Our scheme is constructed in such a way that at any point of time at least 60% of the assets remain invested in debt and it is classified as a debt fund. This is due to the stability that debt/fixed income provides to the portfolio. It brings more predictability to the returns. Equity as an asset class is riskier in the short term but provides capital appreciation over the long term. Thus, one needs to have dynamic allocation for equities."

However, keep in mind that despite maximum allocation to debt securities, the funds carry some equity risk too.

What are the risks?

Monitoring and coordination: Managing a fund with three asset classes requires heavy monitoring. Fund houses are required to have distinct fund managers for each asset class; nevertheless active management of three assets in a single fund would require a lot of monitoring and coordination. Says Gaurav Mashruwala, a Mumbai-based financial planner, “This isn’t a big concern as fund houses ensure that each asset class is managed well."

Accuracy of calls: Additionally, asset calls can go wrong. Gold neither pays dividends nor has an interest component, thus falling gold prices will lead to value erosion. The investment pattern of these funds means that the returns rely a lot on the accuracy of asset allocation calls taken by fund managers.

How to compare returns?

Hybrid funds essentially use multiple assets to manage risk and earn returns. However, returns across funds within this category are very divergent. So how do you choose?

Comparing hybrid funds: Each fund has a specific asset allocation objective and returns are a factor of that. For instance, UTI Wealth Builder II is an equity diversified fund with a 10-35% allocation to gold, whereas Canara Robeco Indigo fund is a debt fund with a 10-35% allocation to gold. There are others that have an allocation across all three asset classes. While all these funds look to take advantage of diversification, their risk-return profile is bound to be very different. Hence, their overall returns can’t be compared; what you can compare is the returns from each asset class separately.

Comparing with other asset allocation-oriented funds: Also, look at the performance of other asset allocation-oriented funds such as balanced funds and monthly income plans (MIPs). Primarily these diversify across equity and debt; balanced funds are more equity-oriented, while MIPs are debt-oriented. According to data from Value Research, an mutual funds data tracking firm, balanced funds as a category have delivered an average of -9.29% and MIPs have delivered an average of -0.36% in the last six months. The returns for the nine hybrid asset allocation funds we have looked at have delivered an average of 2.73% in six months.

Benchmarks are important: There is one fund that falls between the above two categories, Axis Triple Advantage Fund. This fund allocates equally to all three assets (35%) and rebalancing is passive and automatically done on a monthly basis. Here it may work best to evaluate performance against the benchmark.

In fact for other funds too, the benchmark is the most relevant comparison for performance since each fund has a distinct asset allocation and comparing between funds may not give accurate results.

The respective benchmark for each fund is customised according to the asset allocation specified in the offer document. For example, an equity-oriented fund can have a benchmark which comprises 65% of an equity index and 35% price of gold.

What should you do?

Risk profile and tax status: Equity-oriented funds carry higher risk and short-term capital gains from these are taxable at 15%; there is no long-term capital gains tax.

Funds that predominantly invest in fixed income are more conservative in nature (if duration and mark-to-market exposure is low and the portfolio is managed largely on an accrual basis) and aim to deliver consistent returns. These funds are taxed akin to debt mutual funds; short-term capital gains tax is as per the tax slab and long-term capital gains tax is 10% without indexation or 20% with indexation.

The one outlier is Axis Triple Advantage Fund, which invests equally in all three assets and is taxed as a debt fund.

Exit loads: All funds except Fidelity India Child Marriage Plan have an exit load of 1% if funds are withdrawn before 1 year or 365 days. The Fidelity fund has an exit load starting at 3% for redemption before 3 years tapering down to 1% if withdrawn before 1 year.

Asset allocation pattern: Some planners prefer to make that call actively. Says Karthik Jhaveri, founder and director, Transcend Consulting, a financial planning firm, “We prefer to do asset allocation more actively for customers because such funds may not match an individual’s requirement. Moreover, you have to consider the existing portfolio allocation in gold, equity and debt separately and then add this kind of fund."

A look at the portfolio break-up of funds will show the extent of exposure to different asset classes. Says Mashruwala, “We do detailed scrutiny before selecting a (hybrid) fund. It is important to look at the maximum and minimum allocation and whether it matches the strategy we are creating for a client."

These funds enable investors to take advantage of asset allocation without getting into the cumbersome execution. But keep in mind that most of these funds have been in existence for a short period of time and are yet to be tested across asset cycles.