Hybrid Funds: Two Kinds of Holding in a Single Scheme

Hybrid funds are the grouping whose schemes hold both equity and debt inside one portfolio, and the Securities and Exchange Board of India (SEBI) separates the sub-types by how the holdings split between the two. An Arbitrage Fund sits inside that grouping and is the odd one: its holdings are shares, and its outcome comes from offsetting positions rather than from those shares rising. SEBI sets every split condition, and each of them moves.

The scheme categories covered so far sort schemes by what they hold, and the sorting has been clean. One grouping is built on taking part in what companies are worth. Another is built on lending money out and getting it back with interest. A hybrid fundA scheme that holds both the ownership kind of asset and the lending kind of asset in the same portfolio at the same time. refuses that tidiness on purpose: it holds both, at the same time, in the same portfolio. That single decision changes everything else about the scheme, and one member of the grouping turns out not to behave like a mixture at all.

Three things are settled already and are covered separately. A scheme is defined elsewhere, along with who runs it and who checks the runner. A unit is defined elsewhere too, with how its value is struck and which day's value applies to a transaction. So are a purchase, a switch and an exit. Settled as well, under the opening treatment of categories, is that a category is a placement carrying conditions, that a scheme sits in exactly one of them, and that a scheme's name has to match where it has been placed.

One more thing has to be said at the top. Girnar Asset Management Limited, an invented asset manager, runs two schemes so far. The Girnar Large Cap Equity Fund holds the ownership kind only, and the Girnar Broad Market Index Fund tracks a broad index. Girnar Asset Management runs no mixed scheme at all. So the arithmetic below is worked on an illustrative pool of Rs 100/-, and that pool belongs to no scheme anywhere.

What is a hybrid fund actually holding?

Both kinds, in one pool. Picture a household that keeps a small shop and also has money placed in a fixed deposit at the bank. The shop takes part in whatever the business is worth from one month to the next. The deposit is a loan to the bank, repaid with interest, and it does not care how the shop trades. The household has both, and at the end of a year it does not have two separate positions to report; it has one balance, and the shop and the deposit are inside it together.

A hybrid scheme is that household written as a pooled vehicle. One scheme, one portfolio, holding the ownership kind and the lending kind side by side, and one value per unitThe scheme's net assets divided by the units in issue, which is the single price at which a unit is bought and sold. struck from the whole of it. A hybrid scheme is not two schemes in a wrapper, and the difference is not a technicality: there is one pool and one price for a unit of it, so a holder cannot take out the part they like and leave the rest behind. Redeeming a unit redeems a slice of the whole thing, both kinds together, in whatever proportion the pool happened to hold them that day.

The absence of compartments does more work than it looks. Almost every misreading of a mixed scheme traces back to a reader who half believed there were two compartments in there, one of them behaving and one of them not, and who assumed a claim could be made against the well behaved one. There are no compartments. There is a pool.

What separates one hybrid sub-type from another?

One quantity, and only one: the share of the pool held as the ownership part. Everything else about a mixed scheme can vary. The splitHow a mixed pool divides between the ownership kind and the lending kind, usually expressed as the share held as the ownership part. between the two kinds decides which named sub-type the scheme is placed in. The split is the separating axis, and its kind of quantity is worth being precise about.

The split is continuous. A pool can hold none of itself as the ownership part, or all of it, or any position in between, and nothing in the arithmetic changes character at any point along the way. There is no natural joint. A pool a hair either side of any named position behaves a hair differently and not one bit more than that. The sub-types are therefore cuts placed across a smooth quantity by rule, not breaks that were already sitting in it waiting to be found.

Which means somebody has to place them. SEBI does, in the circular that sorts schemes into categories, and it decides both how many cuts there are and where each one falls. The axis is the subject here; the cuts themselves belong to the regulator. A printed cut does not merely become dated when the cut moves, it becomes wrong, and a reader carrying a wrong cut is worse off than a reader carrying none. The current cuts are read at sebi.gov.in, and the classification a scheme's holdings are measured against is read at amfiindia.com.

How does a mixed pool actually move?

By the movement of each part, weighted by how much of the pool that part is. Weighting is the entire mechanism. The working settles the floor question above, so it is worth doing rather than asserting.

An illustrative pool of Rs 100/- stands in, attached to no scheme. Half of it, Rs 50/-, is the ownership part. Half of it, Rs 50/-, is the lending part. Over one stated period the ownership part moves up 10.0 per cent and the lending part moves up 1.0 per cent. Both movements are assumed rather than measured, and any other pair would give the same shape. The ownership half becomes Rs 55.00/-. The lending half becomes Rs 50.50/-. Added together the pool is Rs 105.50/-, so the pool moved 5.50 per cent.

Do it the other way and the same answer arrives. The agreement between the two routes is the check worth having. Weight each part's movement by its share: 10.0 times 0.50 gives 5.00 per cent, and 1.0 times 0.50 gives 0.50 per cent. Five plus a half is 5.50 per cent. The blendThe combined movement of a mixed pool, worked out as each part's movement multiplied by the share of the pool that part represents. reduces how far the pool moves and does not stop it moving. A cushion reduces a fall; a floor would stop one.

Move the split and the whole table moves with it, still on the same two invented part movements. With a quarter of the pool as the ownership part: 10.0 times 0.25 gives 2.50, and 1.0 times 0.75 gives 0.75, so the pool moves 3.25 per cent. With three quarters: 7.50 plus 0.25 gives 7.75 per cent. With none of it as the ownership part the pool moves 1.0 per cent, and with all of it, 10.0 per cent.

The last column shows the shape without stating it. The pool moves 1.0 per cent plus 9.0 percentage points multiplied by the share held as the ownership part. The relationship is a straight line. Check one point rather than take it on trust: at three quarters, 1.0 plus 9.0 times 0.75 is 1.0 plus 6.75, or 7.75 per cent, and the row says exactly that. The line is a finding, not an assertion.

Two things are now proved and one is not. Since 5.50 is less than 10.0 at every split except the two ends, the mixture demonstrably reduces how far the pool moves. The line has no steps in it, so the relationship is continuous. SEBI sets the category cuts, so where any of them falls in that quantity cannot be read off the table at all.

One basis line matters more than it looks. The table's movements are movements in the value of the holdings gross of chargesMeasured before any cost has been taken out, as against a net figure, which is measured after.. A scheme's published return is a net figure, computed from values that already carry the scheme's own expense ratio. The Girnar Large Cap Equity Fund, for instance, returned 13.4 per cent over one stated year measured value per unit to value per unit, and that 13.4 is net because the expense ratio of 1.65 per cent was already inside the values it was computed from. Its stated benchmark returned 12.1 per cent over the same year. An index is not investable and nobody pays anything to hold one, so that figure is costless. Three bases, three different meanings, and which one applies is named every single time.

What happens to the pool as the split slides?

The same arithmetic runs in the calculator below. The slider moves the share of the pool held as the ownership part across its whole range, and the two invented part movements stay exactly where they are, so one thing changes and one consequence follows. The slider opens at half and half, reproducing the worked case above: Rs 100/- becomes Rs 105.50/-, and the pool moves 5.50 per cent.

What happens when the split drifts on its own?

The split stops being the one the scheme was placed under, and nobody has to do anything for that to happen. Drift is the part of a mixed scheme that surprises people, and the reason is simple once it is seen: the split is a ratio between two things that move at different speeds.

Run the illustrative pool forward and watch. The pool started half and half, Rs 50/- in each part. At the end of the period the ownership part is Rs 55.00/- and the lending part is Rs 50.50/-, and the pool is Rs 105.50/-. So what share of the pool is now held as the ownership part? Rs 55.00/- divided by Rs 105.50/- is about 52.13 per cent. The share began at 50.00. The split moved about 2.13 points without a single share being bought and without a single rupee being lent, purely because one part grew faster than the other.

The movement in the split is driftThe change in a mixed pool's split caused only by the two parts moving at different speeds, with no purchase or sale involved., and drift is not a fault. A ratio between two things moving at different speeds does exactly that. But it has a consequence a single-kind scheme never faces: a hybrid scheme can end up outside the shape its sub-type requires while its manager has been sitting perfectly still. Kalyani Bhagat could go on holiday and come back to a scheme that no longer looks like the one she left, without a trade having been placed.

So the framework has to say something about it, and it does. There is a rebalancing windowThe period a scheme is allowed in order to bring a split that has moved back inside the shape its placement requires.: a period within which a scheme that has drifted outside its permitted shape has to be brought back. How long that window is, and exactly what triggers it, is a SEBI condition, read at sebi.gov.in.

What is an Arbitrage Fund, and where does its outcome come from?

An Arbitrage FundA scheme that holds shares and simultaneously holds a position that offsets them, so that its outcome comes from the gap between two prices rather than from the shares moving. is a scheme that holds shares and, at the same time, holds an offsetting positionA position taken deliberately so that it moves against a holding, cancelling most of the effect of that holding moving. in the same shares. Both at once, deliberately, in the same pool.

Here is the everyday version. A wholesaler buys forty kilos of onions in the morning market at one price and, in the same breath, has already agreed to sell those exact forty kilos to a caterer that evening at a price fixed now. She holds onions all day. But she is not betting on onions. Whatever happens to the price of onions between morning and evening reaches her twice, once through what she holds and once through what she has promised, and the two cancel. The difference between the two prices she agreed is what she keeps, less what it costs her to store and cart them.

An arbitrage scheme does the same thing with shares. The scheme holds the shares, and it holds a position that moves against them, so a rise in the shares is met by an equal and opposite movement in the position. The gap between two prices for the same shares is what survives that cancellation. The outcome of such a scheme therefore comes from a gap rather than from the shares rising.

Two things about the arrangement are easy to get wrong, and both are worth stating plainly. First, the cancellation is the design, not a side effect. A hedged holdingA holding whose price movement is deliberately offset by another position, so that the holder keeps the holding without keeping most of its movement. is a holding kept without keeping most of what it does. Second, and this is the sentence that gets skipped: the gap is not free money. The offsetting position has to be established, has to be maintained while it is open, and has to be rolled when it expires, and every one of those has a cost. How a hedge is built and what it costs to keep are covered separately. The arrangement also makes this the hardest scheme in the grouping to place.

Why is an Arbitrage Fund the hardest scheme to place from its holdings?

Because both of the readings a sensible person would try give the wrong answer, and they give it confidently.

The holdings show shares. Every line on the list is equity, so a holdings-first reading files this scheme with the ownership grouping and moves on. The movement of those shares has been deliberately cancelled and what is left comes from a price gap, so the behaviour resembles neither of the two groupings covered so far. Neither reading has said where the scheme sits.

Placement is a decision, recorded in the scheme's own document, against conditions that SEBI sets. Placement is not a property that can be deduced from a list of holdings, anywhere in this framework, and the arbitrage case is the one that proves it. Reading the document and going to the source is therefore the only reliable route, and recognising a category by eye is not a route at all.

There is a second layer, and it is the one readers ask about within about four seconds of meeting an arbitrage scheme. The Central Board of Direct Taxes sets what such a scheme counts as for any other purpose, including how a holding in it is taxed, and its rules are read at incometaxindia.gov.in. A wrong tax figure would do more damage to a reader than almost any other error, and those figures move, so the source is named and the figure fetched from it.

What would a placement card for such a scheme look like?

Blank, mostly, and that is the honest artefact. Below is the card to be filled in about an arbitrage scheme. Four of its rows cannot be filled from a holdings list or from a fact sheet. The fifth cannot be filled from either of those and sits with a different authority altogether.

The card does give the shape of the question and the address of the answer. A shape and an address are more durable to carry than a number. A reader with a blank card and two addresses is better equipped than a reader with a filled card and no idea when it was filled.

What does the hybrid grouping not settle about a scheme inside it?

A great deal, and the list is worth having to hand before any shelf is looked at. Knowing a scheme is placed in a particular hybrid sub-type gives the range its split has to sit inside. The sub-type does not give what the scheme costs, and cost is covered separately. The sub-type does not give which companies sit inside the ownership part or which borrowers sit inside the lending part. Nor does it give where inside the permitted range the manager has actually chosen to sit. And it certainly does not give what the pool will do next.

Two schemes placed in the very same hybrid sub-type can be positioned very differently inside the same permitted range, and a category has nothing to say about that difference. One can sit near one end of what it is allowed to hold and the other near the other end, both entirely within the rules, both carrying the same sub-type name on the front of the document. The name is a boundary, not a description.

Compare it with the Girnar Broad Market Index Fund for a second, purely as a contrast in what a name settles. The index fund tracks a broad index, and its holdings follow that index by construction. A mixed scheme's placement makes no such promise about its contents; it fixes a range and leaves the position inside it to the manager. Two very different amounts of information, both carried by a scheme's category.

Where is every split condition kept?

In two places, and that is the whole answer to carry away. Five conditions are named without being written out: how many sub-types the mixed grouping holds and where each split cut falls; the hedged holding condition behind an Arbitrage Fund; what makes a mixed scheme count as an equity scheme for any regulatory purpose; the window for correcting a split that has drifted; and the rule tying a scheme's name to its placement. Five conditions, one address, sebi.gov.in. Then the sixth: how a holding is taxed, at the Central Board of Direct Taxes, incometaxindia.gov.in.

All six conditions move, and each moves on its own schedule. Anybody who copies the six down holds a paper that is satisfying this morning and wrong within a revision cycle, with nothing on it to say which of the six went stale first.

A method carries further than a summary. Four things can be said about any scheme at all, whatever it is called and whoever runs it. A scheme sits in exactly one category. The category limits what the scheme may hold. Its name has to match where it has been placed. And every value sitting behind those three is fetched from the source rather than remembered. A list of categories ages and a method does not, so four claims plus two addresses carry further than any list.

Girnar Asset Management Limited, the Girnar Large Cap Equity Fund, the Girnar Broad Market Index Fund, Kalyani Bhagat and Sohail Merchant are invented.
Educational material. Not advice on any investment, tax, budget or market position.