Thinkinvestor. Outsourcing your asset allocation

Hybrid funds invest in equity and bonds. In this article, we discuss hybrid funds in the context of your asset allocation decision, given that you will invest in equity and bonds for your goal-based investments.

You must decide how much of your annual savings must be invested in equity and bonds. This decision is based on several factors. First, you must fix the time horizon for your life goal, say, 10 years. Next, you must determine the amount required at end of 10 years to achieve the goal. Then, you must determine how much you can save from your current income towards achieving this goal. Finally, you must make a realistic assumption on the expected post-tax returns on equity and bonds.

Suppose you expect equity to generate pre-tax return of 12 per cent, translating into post-tax return of 10.8 per cent, given 10 per cent long-term capital gains tax. Also suppose you expect to earn pre-tax return of 7 per cent on your bank deposits, translating into post-tax returns of 4.9 per cent, assuming 30 per cent tax rate on interest income.

You can use a spreadsheet to calculate the required return to achieve your goal. This post-tax compounded annual return is referred to as the minimum acceptable return (MAR). The weighted average returns of equity and bonds must equal the goal’s MAR. Solving this equation will give you the asset allocation. Note that your asset allocation will be different for each goal. Now consider a hybrid fund. Such a fund will typically have two portfolio managers to manage the equity component and the bond component. Both components are typically actively managed. Importantly, fund will engage in tactical asset allocation; the proportion of equity and bonds in the fund will vary each year within a mandated range based on the portfolio managers’ return expectations of both markets.

Hybrid funds have benefits. Internal rebalancing (shifting between equity and bonds within the fund) will not trigger tax incidence for you. Also, if the fund holds more than 65 per cent in equity, even the bond returns in the fund will attract only 10 per cent long term capital gains tax when you redeem your units.

They are, however, two important issues to consider. One, the fund will generate capital appreciation from bonds whereas it is preferable to earn income returns for goal-based investments. And two, the fund’s asset allocation may not align with your asset allocation requirement.

(The author offers training programmes for individuals to manage their personal investments)

COMMENT NOW