Capital market regulator Securities and Exchange Board of India (SEBI) in a recent consultation paper has proposed the introduction of hybrid passive funds.
India already has active funds in the different hybrid categories, but as per the current rules, passive funds have to be based on either an equity index or a debt index. Hence, there are no passive funds in this space due to the absence of required frameworks.
But the new proposal for hybrid-passives will allow fund houses to launch passive products (hybrids) that can replicate a composite index comprising fixed proportions of equity and debt and enable investors to invest in a single product having exposure to both equity and debt instruments.
Hybrid funds, as a structure, have been attempting to balance capital appreciation and volatility reduction.
Currently, the three existing categories of active hybrid funds have a total of Rs 2.33 lakh crore in assets under management—29 schemes in the aggressive hybrid funds category, 19 in the conservative hybrid funds category and two in the balanced hybrid funds category.
Once the consultation paper is approved, fund houses can launch hybrid index funds or exchange-traded funds. The thinking is that this will provide more flexibility and diversification opportunities in the passives segment.
Structure of passive hybrids
As of now, SEBI has proposed three types of passive hybrid funds. These are:
Debt-oriented passive hybrid fund: This will limit equity investment to 25 percent of the portfolio. The balance 75 percent of the corpus wil be deployed in fixed-income securities.
Balanced passive hybrid fund: This will have equity and debt allocations set at 50 percent, each.
Equity-oriented passive hybrid fund: This fund will invest 75 percent in equity and 25 percent in fixed-income securities.
You may now be curious to know which index will be used for creating each of these newly announced passive funds.
The regulator has said that for the equity component of these passive hybrid funds, only the broad-based indices from those comprising equity shares from the top 250 companies in terms of market capitalisation are to be used, apart from a list of indices that will be specified by the Association of Mutual Funds in India.
This means that the available universe of stocks is limited to large-caps (the top 100 stocks) and mid-caps (the next 150 stocks).
So, for example, fund houses can choose indices like the Nifty50, Nifty100, Nifty200, Nifty Midcap150, Nifty LargeMidcap 250, etc., for the equity exposure of the passive hybrids.
For the debt part of the portfolio, SEBI has suggested allowing only the constant-duration debt indices.
Also, no sectoral or thematic indices/funds (for equity) or target maturity funds (for debt) will be allowed for hybrid passive funds.
Like in the case of all other categories, here too asset management companies would be allowed to launch only one scheme per category. And the asset allocation has to be maintained/rebalanced on a quarterly basis by the scheme manager.
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Usefulness of passive hybrid funds
The Indian mutual fund industry has been warming up to passive funds and retail investors opting for this avenue have never had it this good. They are now spoilt for choice when it comes to picking right passive fund for their portfolios.
One of the primary reasons to go for passive hybrid funds and not active hybrid funds is that there is no fund manager risk in the former. It is difficult to pick the right active hybrid fund each year, so it is a good idea to go for these newly proposed passive hybrid funds (assuming the allocation of the fund is in line with the goal’s required asset allocation).
Another reason why hybrid funds (and more specifically, aggressive hybrid funds) can be useful is tax-efficient maintenance of asset allocation. Aggressive hybrid funds always maintain between 65 percent and 75 percent in equities and the balance in debt, and they automatically rebalance portfolios and manage asset allocation periodically.
Hybrid fund managers buy or sell equity internally without triggering any tax liability in the hands of the investor. Moreover, even the debt part gets favourable tax treatment since the fund, for taxation purposes, is treated like an equity fund (with 10 percent long-term capital gains tax, etc.). Had this been rebalancing thing been done manually by the investor (between an equity fund and a pure debt fund instead of one hybrid fund) it would have tax implications.
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Conclusion
As I said earlier in an article comparing aggressive hybrid funds with dynamic asset allocation funds, if one wants to maintain a solid equity allocation at all times with automatic tax-efficient rebalancing between equity and debt, using aggressive hybrids can be a reasonably good option.
And now with SEBI opening the doors to the passive route in this category, it is all the more useful for those who are interested in passive-only portfolios. But I would still want to wait and see what kind of funds are launched in this new passive category and which indices they will base themselves on before deciding anything.
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