SEBI Proposes Passive Hybrid Funds: How Will Investors Benefit?

The Securities and Exchange Board of India (SEBI) has recently proposed the introduction of hybrid passive funds through a consultation paper. While India already has active hybrid funds in various categories, current regulations mandate that passive funds must be based on either an equity index or a debt index. This has prevented the existence of passive hybrid funds due to the lack of required frameworks.

The new proposal aims to allow fund houses to launch passive hybrid products that replicate a composite index comprising fixed proportions of equity and debt, thus enabling investors to invest in a single product with exposure to both asset classes.

At present, there are three categories of active hybrid funds with a total of ₹2.33 lakh crore in assets under management. This includes 29 schemes in the aggressive hybrid funds category, 19 in the conservative hybrid funds category, and two in the balanced hybrid funds category.

If the consultation paper is approved, fund houses will be able to launch hybrid index funds or exchange-traded funds (ETFs). This move is expected to offer greater flexibility and diversification opportunities within the passive investment segment.

SEBI has proposed three types of passive hybrid funds:

Debt-Oriented Passive Hybrid Fund: This fund will limit equity investment to 25% of the portfolio, with the remaining 75% allocated to fixed-income securities.

Balanced Passive Hybrid Fund: This fund will have an equal allocation of 50% to both equity and debt.

Equity-Oriented Passive Hybrid Fund: This fund will invest 75% in equity and 25% in fixed-income securities.

For the equity component of these funds, SEBI stipulates that only broad-based indices comprising equity shares from the top 250 companies in terms of market capitalization are to be used. This includes large-cap (the top 100 stocks) and mid-cap (the next 150 stocks) indices. The Association of Mutual Funds in India (AMFI) will specify the list of indices to be used.

For the debt portion, SEBI suggests using only constant-duration debt indices. Sectoral or thematic indices for equity, and target maturity funds for debt, will not be permitted for hybrid passive funds.

The Indian mutual fund industry is increasingly embracing passive funds, providing retail investors with a growing range of options for their portfolios. One significant advantage of passive hybrid funds over active hybrid funds is the elimination of fund manager risk. Selecting the right active hybrid fund each year can be challenging, making the proposed passive hybrid funds an attractive alternative, especially if the fund's allocation aligns with the investor's asset allocation goals.

Additionally, hybrid fund managers can rebalance equity internally without triggering tax liabilities for investors. The debt portion also benefits from favorable tax treatment, as the fund is treated like an equity fund for tax purposes (e.g., a 10% long-term capital gains tax). This would not be the case if an investor manually rebalanced between an equity fund and a pure debt fund, which would have tax implications.

With SEBI now potentially allowing the passive route for hybrid funds, it offers a beneficial option for investors who prefer passive-only portfolios.