Reducing volatility with hybrids

In our previous editions of Weekend Bytes, we have discussed various tenets that an investor could adopt to reduce risks while investing in equities, namely, tenet 1 – Diversification, tenet 2 – Thinking Long Term, tenet 3: Mutual Funds over Direct Stocks and tenet 4: Managing Emotions with SIPs. In this edition, we discuss tenet 5 – Reducing Volatility with Hybrids.

In Hindustani Classical Music, an octave, also known as Saptak, comprises of the following 7 notes – Sa Re Ga Ma Pa Dha Ni. Interestingly, every song is created using a combination of all the 7 notes. By judiciously combining these notes, a composer makes listening to music, a stress-free experience.

Just like this combination equates to a stress-free experience, allocating to different asset classes helps in making an investor’s investment journey less stressful.

How does Asset Allocation make an investor’s investment journey less stressful?

Primarily, an investor can consider allocating towards 3 asset classes, namely:

• Equity: Providing growth of capital
• Debt: Providing stability to capital
• Commodity: Hedge against inflation and uncertainties

While each asset class has a specific role to play, different asset classes perform differently under each market cycle. For example, while equity markets fell sharply during onset of COVID-19 pandemic, gold prices saw a rise during the same period.

Standard deviation, a parameter used to measure volatility, measures the dispersion of a series of variables from its mean. For instance, if the returns of a fund vary in a narrow range, the standard deviation will have a relatively lower value, which means lower volatility and vice versa.

As these asset classes have low or negative correlation amongst themselves, investment in multiple asset classes can help in reducing the volatility of the overall portfolio during period of sharp movements in a single asset class. This non-linear relationship between the asset classes is the key reason for hybrid funds being a great addition to an investor’s portfolio.

For further clarity, let us have a look at the graphs below. Taking one scenario from Chart 2 – An investor’s portfolio has an allocation of 60% towards equity, 30% towards debt and 10% towards gold. For this portfolio, in comparison to pure equity, while the compounded annualized returns over 20 years fell by a mere 1.7%, the volatility has reduced significantly – by 7.4%!

The above combinations are for illustrative purpose. Data used for asset classes: Equity – NIFTY 50, Debt – NIFTY 10-year Benchmark GSec, Gold – Spot Rate INR/10 Grams. Source: www.niftyindices.com , World Gold Council. Data for last 25 fiscal years from April 2002 to February 2023 is used. Returns are compounded annual in nature. Monthly portfolio rebalancing assumed. Standard Deviation calculated using daily returns. HDFC Mutual Fund/AMC is not guaranteeing future returns of these asset classes. Investors are requested to take professional advice while making investment decisions.

Choosing from the Range of Hybrid Funds

While there are multiple choices to opt from the range of Hybrid Funds offered by HDFC MF, it is important to assess risk tolerance level before choosing a hybrid fund. Based on the asset allocation, especially the exposure to equities, one hybrid fund differs from another. The equity allocation can range from minimum 10% to maximum 100%, and there are six different hybrid funds to suit different investor segments from conservative to aggressive:

Conclusion

While equities can provide growth to an investor’s portfolio, as discussed in the earlier tenets, managing emotions could be tricky because equity markets are volatile in the short term. Against this backdrop, hybrid funds can be a useful addition, as it can not only reduce the portfolio volatility, but also aid the investor in the thinking long term.

Over the course of this series, we have discussed multiple key tenets that help in reducing risks while investing in equities, but is there anything that an investor should keep in mind?

Tune in for the next edition of this series to know more!

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