Investors are easily attracted to any investment avenue which has “capital protection” as it indicates safety of principal amount invested. However, it is important to understand the basics of any investment before plunging into it.
Let us look at capital protection-oriented mutual funds (MFs), which are closed-end in nature. The term closed-end means subscription is open only during the new fund offer (NFO) period and after that, there would not be any fresh subscription or redemptions from capital protection funds.
What are these?
Coming to the concept of capital protection-oriented funds, asset management companies (AMCs) launch these funds with both debt and equity components. If it were done with debt only, it would be similar to fixed maturity plans (FMPs) and FMPs sell even without the comfort of capital protection orientation. The equity component (around 20% of the portfolio) gives participation in the potential upside (meaning higher returns) from the equity market, while the debt component (around 80% of the portfolio) ensures capital preservation by virtue of the defined maturity date of these instruments. As per the rules of the Securities and Exchange Board of India (Sebi), an MF scheme cannot use the term “guarantee” or “capital protection” in its name, but can use the term “capital protection-oriented” if it abides by certain requirements. These requirements are that there has to be a credit rating for the scheme and the debt component should grow to the initial amount invested (i.e. the principal amount) over the tenor of the scheme. Let us say the credit rating agency mandates the fund to purchase only AAA rated—which are the topmost rated—debt securities and they find that as per the yields available in AAA rated debt instruments, 80% of the portfolio would be enough to grow to the principal amount, net of fund management expenses over the tenor, say three years. This would leave 20% of the portfolio free for the equity component.
How do they work?
Capital protection-oriented funds may either be “plain vanilla” or “leveraged market participation”. Let us further understand: in the above example, 20% of the portfolio of the fund is invested in equity stocks, which we are calling “plain vanilla”. “Leverage” means taking the equity market participation to a much higher extent even without reducing the debt component. This is possible by purchasing call options on Nifty with a tenor equal to that of the fund. For example, if the price of a three-year Nifty call option is 20% of the value, the participation in equity market would be 100/20 = 5 times or 20% x 5 = 100%. With the deft use of leverage, even after investing 80% in debt, it is possible to have 100% participation in the equity market. The point to be noted here is that it is only an “option” to buy Nifty at today’s level after three years and there is no compulsion to buy it if the market level is lower. The flipside is that if the equity market does not move up significantly, the price paid for buying the Nifty call options would not be recovered fully. In such a situation, it would have been better to invest in a plain vanilla fund, which would have given relatively higher returns. Apparently, a higher equity upside participation is better as the investor benefits that much more if the equity market moves up. However, it works only when the equity market moves up above a threshold. There is a cost of the higher (leveraged) equity market participation—the premium paid for purchase of Nifty call options. If the equity market stays flat, the cost is not recovered. In a plain vanilla fund, even if the equity market remains flat, the value of 20% of the portfolio would remain at a similar level after three years.
Who should buy?
Capital protection-oriented funds are suitable for people who have defined financial goals or require cash flows as the time of maturity is known while making the investment. In the interim period, liquidity is poor; though listed at the exchange, the possibility of finding a buyer for these funds is low. Those who expect the equity market to move up over a period of time but are not sure of it and hence require a safety net (80% debt component in our example) would find it useful. Those who are relatively more bullish on the equity market should choose the leveraged market participation variety.