Most investors like to own a mix of different investments. Those who use mutual funds are used to having multiple types of funds at their disposal to give them exposure not just to broad asset classes like stocks and bonds, but also to more targeted areas within those asset classes. But for those who want to keep their fund portfolios simple, hybrid funds offer a way to get universal exposure to multiple asset classes within a single investment vehicle.

That sounds great for those looking for a one-stop shop for their investing needs. But now might not be the ideal time to use most hybrid funds, because the mix of asset classes that most offer have some risks that could hurt long-term returns.

Lens of a pair of glasses in front of Mutual Funds page of the newspaper.

Image source: Getty Images.

What a typical hybrid fund looks like

Most hybrid funds offer a combination of stocks and bonds within a single fund. The idea behind the strategy is that over the long haul, stocks have tended to grow more quickly than bonds, and bonds have tended to provide more income than stocks. Moreover, the combination of the two together has often provided some diversification value that either one by itself lacks. For instance, in many stock market downturns, bond prices would rise, helping to make the hit to a balanced portfolio less extreme than for a pure stock mutual fund.

You can find hybrid funds that take on different levels of stock market risk. For instance, the Vanguard Wellington Fund (NASDAQMUTFUND:VWELX) has more of a lean toward stocks, with about a 65% to 35% split between stocks and bonds. That gives the Wellington fund a more aggressive tilt than hybrid funds with less exposure to stocks, because stocks tend to be more volatile over the long run than bonds are.

By contrast, the Vanguard Wellesley Fund (NASDAQMUTFUND:VWINX) takes the opposite approach. It puts the majority of its assets, between 60% and 65% at most times, in various bond investments. The remaining 35% to 40% goes into the stock market. That makes Vanguard Wellesley a more conservative choice for hybrid investors looking for income and growth.

When hybrid funds can be dangerous

One of the biggest reasons hybrid funds have performed as well as they have historically is that the bond market has seen a gradual decline in interest rates and rise in prices that has lasted since the 1980s. From double-digit levels back then, bond yields have now fallen to extremely low levels, sending even the longest-maturity Treasury bonds to levels below the 3% mark.

That was beneficial for hybrid funds, because when rates rise, the value of the bonds those funds hold goes up as well. That, added to the interest the bond investments produce, led to attractive total returns for the bond portion of the funds. Combine that with bull market conditions in the stock market over the past nine years, and you get a powerful mix of upward-moving investments.

Yet the fact that bonds and stocks have both risen in value at the same time during the early and mid-2010s shows that they could both fall in value in the future as well. During the recent stock market correction, major stock market indexes fell 10% even as the yield on the 10-year Treasury moved toward its highest levels since 2014. That sent the value of both asset classes downward, and even hybrid funds designed for safety suffered significant losses.

Longer term, many investors believe the bond market is poised to reverse its decades-long bull market and start heading higher. If that happens, then bonds will weigh on a balanced portfolio. Even if stocks manage to rise in a higher interest rate environment, those gains will get watered down by losses on the bond side of the portfolio.

Keep your head in the game

Hybrid funds are simple, but they don't give you enough control to avoid this potential risk. Instead, you can use a stock mutual fund for your stock exposure, but use a combination of savings accounts and bank CDs to get the fixed-income exposure you want. Unlike bonds, the value of CDs won't go down if rates go up, and you can always get access to your money in exchange for whatever early withdrawal penalty your bank charges.

Hybrid funds have produced amazing returns, but they might not be as likely to do so going forward. With tailwinds in the bond market having turned to headwinds, investors need to face the potential of weaker returns for hybrid funds in the future.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.