Playing it Safe

When presented with the 'Hybrid: Debt-oriented Conservative' category, eyebrows are raised. Not surprisingly. It appears confusing. This nomenclature is given to funds that are more popularly known as MIPs or monthly income plans. So why have we not said so upfront? Because we do believe that it conveys a false impression that these funds provide investors with a regular monthly income. Nothing could be further from the truth. Yes, they will attempt to give dividends periodically, but they are not mandatorily obligated to do so.

Any market related product, which this is, is not permitted to provide a guaranteed return. So neither the dividend nor the capital appreciation is a given. These funds are not obliged to make any kind of monthly payment and the dividends are always subjective to the availability of surplus cash with the funds.

Also remember that regularity of dividends in the past is no guarantee of the same in the future. Furthermore, even if the fund continues to pay a dividend regularly, there is no guarantee of the quantum of dividend declared monthly. It keeps varying with the performance of the fund.

The hybrid classification
Universe: Open-ended hybrid funds
Exclusions: Arbitrage funds, asset allocation funds
Classification: On the basis of average equity exposure over the past year
* Hybrid: Debt-oriented Conservative: 0-25%
* Hybrid: Debt-oriented Aggressive: 26-60%
* Hybrid: Equity-oriented: Above 60%

So what exactly are these funds all about? These are hybrid products that add a dash of equity to their predominantly debt portfolio. The latter provides stability to the portfolio while the (minority) equity holding adds that extra zing. Since the equity allocation can go right up to 25 per cent, it does raise the level of risk significantly over any other debt instrument as the chances of capital depreciation are high. In a situation like 2008, when the equity market plummeted, 37 out of the total 45 funds delivered a negative return that year with six of them witnessing a loss between 10-12 per cent. The worst annual performer was ICICI Prudential MIP 25 at a loss of close to 12 per cent. In fact, it delivered the worst monthly performance in its history in the September-October 2008 period (-11%).

So while these funds can surely augment your source of income, do not make them the prime source of your monthly inflows. If you are looking for a regular source of income, consider a bank fixed deposit, a monthly income scheme from the post office or a Senior Citizen Saving Scheme (SCSS), if you qualify. The only issue is that with such avenues, you cannot expect any capital appreciation which an equity linked product will give you. At the completion of the tenure of the investment, all that you have left is the initial investment. And once you discount for inflation, the value of your initial investment will be much lower.

This is where MIPs give you an edge. The equity portion makes it possible for the fund to deliver inflation-beating returns over a few years. The best way to approach such an investment is to invest for the long term to partially reduce the risk of capital loss.

We looked at the performance of the top five funds of this category by asset size over a five-year period. If one had invested Rs 10 lakh and systematically withdrawn Rs 6,667 per month (that is 8% p.a) from each of these funds, four were able to provide capital appreciation at the end of five years. All saw the value of the initial investment dip temporarily in 2008 and 2009, but over the long term they were winners.

This category of funds provide a ready-made portfolio to investors who want the bare minimum equity exposure in a predominantly debt portfolio. On the flip side, they can design their own such hybrid portfolio by choosing an equity and debt fund and distributing the assets proportionately. But then they will need to continuously monitor and rebalance. This is by far a much more convenient route to take. We present you with the best options.

Playing it smart
* Despite having a predominantly high debt allocation, keep a long-term perspective in mind when investing in these funds.
* Instead of opting for the dividend option, consider a Systematic Withdrawal Plan (SWP) which will be tax efficient and provide certainty of inflows. Fix the amount you want to withdraw from the fund on a monthly, quarterly or semi-annual basis. This way you control the frequency and quantum of flows.
* If possible, start the SWP after a year of investment to avoid short-term capital gains tax in the first year. Long-term capital gains tax is 10 per cent with indexation and 20 per cent without indexation. Dividend tax (@12.5%) is paid by the fund house and is tax free in the hands of the investor but is taken out of your fund. So the net amount you receive as dividend is after the tax has been deducted.
* If capital protection is of utmost priority to an investor, then schemes with an equity component must be avoided. The equity allocation does boost returns but can even lead to its tumble.
* When considering the aggressiveness of such a fund, do note that the equity exposure is just one aspect. What really matters is the actual allocation to equity, market cap bets and stock concentration which will determine how aggressive the fund is. The aggressiveness on the debt portfolio will be displayed in the credit bets and average portfolio maturity.