How Hybrid Funds Can Mitigate Various Investment Risks

While returns can guide investment decisions, the real challenge lies in understanding and managing the various risks – be they personal, portfolio-related, behavioral and even perception.

A broader classification of risks could be based on what we know, what we don’t know, and unpredictable events.

Risk management is the key to generating optimal long-term returns so that all of an investor’s financial objectives are achieved within the required time frames.

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See how risks can be managed systematically.

Risk-return balance

Equities are long-term wealth generators, with the Sensex delivering a compound annual growth rate (CAGR) of approximately 15% over the last 40 years.

Stock prices are shaped by company earnings, industry trends, economic prospects and broader market cycles. When investors buy companies with high growth potential, led by strong management teams and capital efficiency, with correct valuations, they can achieve healthy returns.

Fund managers mitigate known risks by focusing on the right sectors and stocks, taking calculated risks, and making decisions based on fundamentals rather than market narratives.

However, unknown risks such as election results, geopolitical tensions, interest rates and regulatory changes require careful consideration. These risks can be managed through portfolio diversification and disciplined investment practices.

Unpredictable risks include war outcomes, global investors’ risk perception, China and US macroeconomic and trade issues, COVID-like pandemics, and so on.

These issues are addressed through asset allocation, systematic investment across cycles and an objective-focused approach to minimize the risk of not meeting financial objectives.

Returns do not come without risks. The idea is to embrace the right risks.

This involves paying reasonable prices for growth, focusing on sustainable businesses, and avoiding herd mentality and unsustainable valuations.

Investors should reject unsustainably high valuations, even for large companies, ensure correct diversification without too much dilution, avoid excessive leverage, choose category leaders in cyclical sectors, and use negative news to enter the right stocks and sectors.

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A well-diversified portfolio with category leaders and strategic stock picks can help manage risks effectively.

A balanced approach

To achieve desirable risk-adjusted returns, it is critical to create a suitable asset allocation strategy. This involves aligning investments with the investor’s risk appetite, financial goals and available surplus.

By spreading investments across equities, fixed income and gold, investors can mitigate risk by remaining fully invested throughout market cycles.

For retail investors, the best way to go about asset allocation is to consider hybrid mutual funds for your goals.

Hybrid indices tend to have lower volatility compared to equity indices like Nifty, resulting in reduced risk.

Uncorrelated Assets: Investing in hybrid funds would ensure exposure to equity and debt or even a combination of equity, debt and gold/other assets. Over the last 15 years, these asset classes have outperformed at different times, ensuring balanced growth and reduced portfolio volatility.

In the last 15 calendar years, from 2009 to 2023, equities (Sensex) have outperformed in 7 calendar years, fixed income (CRISIL Short Term Bond) in one year and gold (MCX prices) in seven years.

Equity and gold are negatively correlated, so they move in opposite directions. Debt and gold have a very low correlation, and equity and debt have almost no correlation. Therefore, investing in a combination of these assets reduces portfolio volatility.

Simpler asset allocation: Hybrid funds of different categories would decide asset allocation between schemes through rigorous research and internal models. Decisions about increasing or reducing exposure to specific asset classes are more fluid, with fund managers making informed choices based on valuations, market conditions and internal strategies.

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Flexibility in style: In addition to the general guidelines set by the Securities and Exchange Board of India (SEBI), hybrid funds offer significant flexibility in selecting investment style for each asset class. This allows fund managers to adopt multi-cap or flexi-cap approaches for equities and apply active duration, accumulation or other strategies for fixed income, depending on factors such as interest rates, inflation and macroeconomic indicators.

Suitable for lump sums and SIPs: An important advantage that hybrid funds bring is that they are suitable for both lump sums and systematic investment plans (SIPs), as the timing of entry is less relevant compared to pure equity funds.

Sailesh Raj Bhan is CIO-equity at Nippon Indian Mutual Fund.