Capital protection mutual fund scheme? Beware!

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. They target the need for safety of initial investment that has so far kept conservative investors out of the MF ambit and to provide returns attractive enough to lure them away from guaranteed return products.

The performance of existing monthly income plans and hybrid debt oriented schemes show that funds are capable of generating superior returns with a high degree of safety. However, investors need to read the fine print on the protection of capital, liquidity, expected returns and risks before committing to these schemes.

Sebi's guidelines

In August, market regulator Securities and Exchange Board of India issued guidelines permitting fund houses to launch "capital protection-oriented" schemes. Sebi says capital protection should arise from the way in which the portfolio is constructed and not from any guarantee by the asset management company or sponsor.

It also requires that the scheme be rated by a credit rating agency on the ability of the fund to protect the initial investment and to be periodically reviewed on its continued ability to do so. Also, these schemes have to be closed-end, so investors can invest only at the time of the new fund offer and can redeem only on the completion of its term.

The modality

How do these funds aim to provide capital protection? 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. 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 securities that are expected to provide returns that make the investment proposition attractive. This is something that an investor can easily replicate by parking the funds in, let us say, a post office monthly income scheme and investing the monthly interest in the equity market. However, the advantage that fund houses would bring is the use of sophisticated tools such as constant proportion portfolio insurance and dynamic portfolio insurance to apportion and manage funds between less risky assets and risky assets.

Unlike the example above, where the investment in equity was restricted to the cushion of Rs 20, the exposure to equity is leveraged with  a defined multiplier. In the same example, if the multiplier is three, then Rs 60 (20x3) will go into equity and Rs 40 into risk-less 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. This would ensure that investors 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. The other advantage is that investing in a mutual fund is more tax efficient than investing directly.

Buyer beware

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, the investor needs to keep in mind certain issues before being carried away by the capital protection bit, which is what the fund houses and distributors will emphasise on. These are:

No Guarantees. Sebi's guidelines do not require the fund house to give any guarantees. In other words, the AMC isn't required to make up the difference in case of capital erosion. They only need to ensure that, as far as possible, the investor's initial investment is safe, by structuring the portfolio in a way that ensures protection.

More importantly, these schemes 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 investors 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. The credit rating that Sebi insists on will also provide an added level of security for the investor.

Low liquidity. Capital protection funds are essentially closed-end funds, wherein an investor can't exit during the life of the scheme for any reason, be it need for liquidity, or poor performance by the scheme. The first capital protection fund in India, Franklin Templeton Capital Safety Fund, is mulling listing on the stockmarket to give investors an exit option.

The experience of closed-end funds listing on stock exchanges has not been happy with the units quoting on the exchanges at heavy discounts to NAV. This makes it essential for the investor to be able to spare the funds for three or five years, as the case may be, for which funds would be locked up.

Moderate returns. If you invest in the belief that returns from funds will match that of diversified equity funds when markets go up and reflect a fixed deposit in a bear market, you would be disappointed. A capital protection fund's focus is protecting the capital. Only a portion of the funds will be invested in equity and related instruments and returns to investors are going to be muted to that extent.

A look at the returns from MIPs and hybrid debt funds, which have a blend of debt and equity that is similar to the mix that capital protection funds will have, may give an idea of the returns that investors can expect (see Count Your Bucks).

 The closed-end nature of these funds permit active portfolio allocation strategies by the fund managers, increasing equity exposure when markets are going up and the reverse when markets dip. This will give the capital protection funds an advantage in generating returns.

Return risk. The risk for an investor in a capital protected fund will not be of losing capital invested. The risk for the investor would be of not getting expected returns. The challenge for fund managers would be to be able to allocate sufficient resources to risky assets to generate returns.

For example, in a phase when interest rates are going down, greater allocation will have to be made to the debt component in order to offset the reinvestment risk and to ensure that the redemption value of the bonds at the time of maturity equals or is greater than the amount invested.

This would mean less exposure to equity products and that would greatly reduce the potential gains that a fund can achieve from subsequent gains in the stockmarkets. To put things in perspective, a look at the returns from MIPs show that funds that have at least 15 per cent in equity have fared better in all periods.

Tax implications. Dividends from the scheme will be tax free in the hands of the investor. However, since these schemes will invest predominantly in debt, the fund will have to pay a dividend distribution tax amounting to 14.02 per cent.

The long-term capital gains tax on redemption will be 10 per cent without inflation indexation and 20 per cent (excluding surcharge and education cess) with this benefit. Income from fixed return products like bank deposits, on the other hand, will have a higher tax incidence at the marginal rate of tax applicable to the investor and the capital protection funds are a more tax effective way for the investor to invest, especially for investors in higher tax brackets.

Buying the scheme. Caveat Emptor or buyer beware is a policy that will always hold the investor in good stead. Investors must guard against wrong claims made by distributors either out of ignorance or otherwise. Investors are going to be sold this product as a guaranteed product by distributors, who will find this the easiest way to convince an investor. The other issue on which the investors could be misled is expected returns.

These are predominantly debt funds that will have a limited exposure to equity and, therefore, the returns can't be compared to that of an equity fund.

After Sebi came out with the guidelines, the MF industry has lined up a host of capital protection funds. Franklin Templeton was first off the mark with its Capital Safety Fund. Reliance, UTI, Tata, and SBI have filed draft prospectuses with Sebi for similar products.

These funds are ideal vehicles for the conservative investor waiting to participate in equity marktes without risking their capital. 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.  

The Flip Side

Three reasons why capital protection schemes may not work for you

• Guarantee. No AMC or sponsor guarantee against capital erosion. A high debt component means typical debt investment risks related to interest rate, default and reinvestment
• Liquidity. It's less liquid being closed-end. Investors can invest during NFOs and redeem it either after the end of the term or if it gets listed
• Returns. Likely to be much less than diversified equity funds and more in line with monthly income plans