How hybrid funds can mitigate various investing risks

While returns may drive investment decisions, the true challenge lies in understanding and managing the various risks—whether personal, portfolio-related, behaviour and even perception.

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

Managing risk is the key to generating optimal returns over long term, so that all the financial goals of an investor are met within the requisite timelines.

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Here’s how risks can be managed systematically. 

Risk-return balance

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

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

Fund managers mitigate the 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 by portfolio diversification and disciplined investment practices.

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

These are addressed through asset allocation, systematic investing across cycles, and a goal-focused approach to minimise the risk of missing financial targets.

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 great businesses, ensure right diversification without too much dilution, avoid excessive leverage, pick the 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, creating a well-suited asset allocation strategy is key. This involves aligning investments with an investor’s risk appetite, financial goals, and available surplus. 

By distributing investments across equities, fixed income, and gold, investors can mitigate risk while remaining fully invested through market cycles.

For retail investors, the best way of going about asset allocation is to consider hybrid mutual funds for their goals.

Hybrid indices tend to have lower volatility compared to equity indices like the 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 past 15 years, these asset classes have outperformed at different times, ensuring balanced growth and reduced portfolio volatility.

In the last 15 calendar years from 2009-2023, 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 have negative correlation, so they move in opposite directions. Debt and gold have very low correlation, and equity and debt have near-zero correlation. Thus, investing in a combination of these assets reduces portfolio volatility.

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

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

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

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