Sriram asks, “Why not just use an aggressive hybrid mutual fund for long-term goals instead of investing in equity funds and fixed income securities separately and then worrying about rebalancing and paying taxes? This has both equity and fixed income securities. The rebalancing is done automatically and we don’t have to pay any taxes. “

At first glance, it seems like a good idea and, in principle, quite feasible. However, aggressive hybrid funds are only a notch or two less volatile than equity funds. For example, the maximum loss in a portfolio investing in the CRISIL 65% Equity 35% Debt Hybrid Index is 17% for a five-year period between January 2011 and June 2021.

If the portfolio only had Nifty 500, the maximum loss over that period would be 29%. That is, the Aggressive Hybrid Index suffers about 60% of the equity index loss. When so worded, it seems obvious and trivial. If we extend the study period to the mid-1990s and the investment period to 15 years, the maximum loss for the stock index is 60%.

If we assume that the hybrid index suffers 60% from a 60% loss, it is still 36%. It’s one thing to backtest and report it and quite another to invest in a fund and see its value go down so much. More importantly, the stock allocation of aggressive hybrid mutual funds is typically around 5-20% higher than 65%. So the losses would be higher.

For the 5-year study, the maximum time the Agg hybrid fund was underwater was around 5 months. Just a month less than a 100% equity portfolio. Now for the 15-year study, the 100% equity portfolio was underwater for 40 months. Even if we (incorrectly) assume that the Agg Hybrid Fund’s portfolio would only be 60% of that period under water, it is still 24 months or two years.

The volatility of the equity portfolio of 100% over 5 years, measured by the standard deviation, is between 23% (max) and the upper 12% (min). The corresponding figures for the agg hybrid portfolio are 16% (max) to 8% (min).

Even investors who claim this volatility and disadvantage are acceptable to them will need to consider another bond option in a few years’ time to reduce the risk of the portfolio as it nears its target date. This risk reduction is an ongoing process that must start well in advance.

A one-fund portfolio with an aggressive equity fund would be just as volatile to most investors as investing in an equity fund. We therefore recommend that investors treat aggressive hybrid funds as pure equity funds (without taking into account the debt component) and only include them as part of a balanced asset allocation with regular rebalancing and continuous risk reduction; for example 50 to 60% aggressive hybrid funds and the remainder fixed income. The fear of paying taxes (or saving taxes) should never be the primary consideration when making an investment decision.

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