Well-cradled Capital!

This is exactly what you wanted -- a mutual fund scheme that promises to protect your initial investment and gives better returns than a bank fixed deposit and other guaranteed products on offer. A magic magnetic force attracting you into the Mutual Fund ambit! Should you let yourself be attracted or repelled?

Capital Protection Funds are essentially a simplified version of structured products with investments made in high quality debt, which typically commands lower yields, while simultaneously taking a small exposure to a more risky asset, equity. Structured products are already highly popular in Europe. They are beginning to make their mark in India with a deluge of funds from reputed fund houses like Franklin Templeton, UTI, Deutsche, DBS Cholamandalam, Prudential ICICI, Birla Sunlife, Sundaram BNP Paribas…

The wary watchdog

In August 2006, market regulator Securities and Exchange Board of India (SEBI) issued guidelines permitting fund houses to launch "capital protection-oriented" schemes. SEBI said capital protection should arise from the way in which the portfolio was constructed and not from any guarantee by the asset management company or sponsor. It also required that the scheme be rated by a credit rating agency on the ability of the fund to protect the initial investment. The rating had to be reviewed on a quarterly basis and AMCs had to ensure that the debt component of the portfolio had the highest investment grade rating (AAA or P1+). In addition, these schemes should be closed-end, so that you could invest only at the time of the new fund offer and could redeem only on the completion of its term or if it gets listed.

I would like to draw your attention to the fact that the guidelines talk about an effort to protect capital. There is no mention about the effort actually having to succeed!

The modus operandi

To ensure that you are able to reap maximum benefits by participating in an asset class that gives better returns without compromising on the safety of the capital invested, a portion of the

fund is invested in debt instruments that would mature at the value of the initial investment at the time of redemption and the remaining in equity. For example, out of Rs 100, Rs 80 may be invested in an interest-paying debt instrument or zero-coupon bonds, whose maturity value is Rs 100. The remaining Rs 20 is invested in equity. Over a three to five-year period (which is the tenure of such funds), however, it is reasonable to expect a modest return from equity. Even if equity returns nothing, you still have your capital intact.

This is something that you can easily replicate by parking the funds in a Post Office Monthly Income Scheme (POMIS) and investing the monthly interest in the equity market. However, the advantage that fund houses would bring is the use of sophisticated tools to manage funds between less risky assets and risky assets. The protection is at risk only if the value of the portfolio falls below the floor, Rs 80, and this is monitored on a continuous basis with built-in triggers.

A double-edged sword…

Capital protection funds are excellent tools for fund houses because they are able to tap into a source of funds that have so far been cornered by bank deposits or post office schemes. However, you need to keep in mind certain issues before being carried away by the capital protection bait. Capital protection funds aim to protect your rupee investment and inflation is ignored. This means that even if you get the Rs 100 that you had invested, effectively you have lost money because of the value erosion in the Rs 100 over the period. Does this mean that you will lose money? Not likely. The closed-end nature of these schemes gives the fund manager the defined period benefit for making investments in debt instruments which ensure protection but the liquidity aspect takes a severe beating (you can invest only that portion of your money that can be set aside for 3 to 5 years). The credit rating that SEBI insists on will also provide an added level of security for you.

The long-term risk-free returns that you can earn in the Indian economy will stay limited to perhaps 3% or 4% above what you could earn by putting a fixed deposit in a bank. A modest return slightly more than an FD without risk is a pretty good deal. However, if you are somehow led to believe that these funds will reach up to the stars along with the index during bull runs and then miraculously not fall when the markets nosedive, then you are in for a rude shock. In real life, these funds will rise gently when the market shoots up and will go down less than they went up earlier when the markets reach their nadir.

… the cutting edge?

Capital-protection-oriented funds are predominantly debt funds that have a limited exposure to equity and, therefore, the returns cannot be compared to that of an equity fund. The fund can make an apt fit if you are a low to moderate risk-taking investor since it offers an opportunity to invest in a market-linked investment avenue without compromising on your risk profile. This fund would be all the more appealing if you are in the highest tax bracket or close to retirement. A cradle for the capital invested … But if you are an investor with a long-term perspective and not hung up on capital protection, you are better off investing in a well-managed diversified equity fund.