If you’re looking to preserve your capital as well as get humble returns on your investment with lesser exposure to market risks, capital protection funds could be an option for you -By Shivram Yedithi

The stock market is in mayhem with bearish sentiment ruling the roost. A tumbling rupee, slowdown in economy and companies reporting tepid quarterly results in the ongoing earnings season has made it further difficult to project the future course of the market. The National Stock Exchange’s (NSE) benchmark Nifty is down 6.4% year-to-date (as on April 15, 2013) while Bombay Stock Exchange’s bellwether S&P BSE Sensex is trading down 6.24% YTD.

In the current uncertain time if you’re worried and clueless, like scores of retail investors, over where to invest your hardearned money, Capital Protection Fund could be a safer option for you. The basic premise of a capital protection fund, a close-ended hybrid fund, is that investors should get their capital back.

Similar to MIP, these funds invest predominantly in debt ranging from 70%- 90% and the rest is invested in equity. The objective of the scheme is to generate fixed return or earn cumulative amount on invested capital by investing in debt papers maturing in line with the maturity of the fund and to invest the remaining amount in equity to generate capital appreciation. Normally the tenure of the scheme is one, two and three years.

How the Fund Works

Investing in capital protection funds is a good proposition for investors looking to preserve their capital considering the extended volatility in the markets with no clear direction. The idea of the fund is to safeguard the capital and invest predominantly in a mix of debt and equity with major share going towards the debt.

To illustrate this better, let’s consider a simple case that you invest Rs1,000 in a three-year capital protection fund, which, in turn invests Rs800 (80%) in debt papers with a coupon of 8.50% p.a. Over a period of three years, Rs800 would grow to Rs1021.83. However, assuming that the remaining equity investment of Rs200 falls by 10% on an absolute basis, your capital still remains safe (Rs1021.83-Rs20 = Rs1001.83) over a period of three years. This is the advantage of a capital protection fund.

Creating Your Own Portfolio

Though it may not be a feasible option for everyone, but you as an investor could try out creating your own capital protection portfolio and invest in the ratio of your choice depending on your risk appetite, instead of investing in a fund wherein the mix is decided by a fund manager.

For example, you can create your own mix by investing 80% of investible amount in, say, Fixed Maturity Plans of certain tenure or investing in a debt mutual fund of certain maturity and investing the remaining 20% in a multi-cap/large cap/small & mid cap depending on your risk appetite. However, you’ll have to bear in mind that it’s not a get-rich-quick approach and you should be willing to hold on to both equity and fixed income instruments for a period of 3 to 5 years which is generally the maturity of capital protection funds.

Let’s try and work this out through an illustration. Mr A has investible surplus of Rs1 Lakh. Let’s consider two scenarios for him. In the first case, Mr A invested 80% (Rs80,000) in a 3-year FMP earning around 9% p.a (assumed return) and invested the remaining 20% (Rs20,000) in equity, earning an absolute return of 10%.

After three years, the pre-tax amount on FMP grows to Rs1,03,602.3 (at assumed rate of return of 9% p.a) while equity investment grows to Rs22,000 (absolute return of 10%), taking the total amount at the end of three years to Rs1,25,602.3. That means after three years the absolute return on your investment comes out to a whopping 25.60% while annualized return a decent 8.53%.

Let’s now look at the second scenario wherein Mr A’s equity investment loses by an absolute 10% in the same period. In this case, while the pre-tax amount on FMP rem a i n s t h e s a m e Rs1,03,602.3 the equity return dwindles to Rs18,000, shrinking the total return at the end of three years to Rs1,21,602.3. However, his exposure of 80% in debt instrument protected his corpus from getting vanished due to equity market mayhem. The upshot: despite losing 10% on his investment, Mr A still managed to get an absolute return of 21.60% ad an annualized return of 7.20% after three years.

Indexation Advantage

Don’t forget that you’ll have to pay tax that is applicable on the earnings from Fixed Maturity plans at 10.30% without indexation and 20.60% with indexation. Let’s see how it works out without indexation benefit. The capital gains on your FMP amounts to Rs23,602.32 (Rs1,03,602.3- Rs80,000) without indexation while tax on this capital gains without indexation comes to Rs2,431.04 taking the post-tax amount on FMP to Rs1,01,171.26 (Rs1,03,602.3- Rs2,431.04).

If you add equity returns of Rs22,000, the total post-tax amount at the end of 3 ye a r s c o m e s t o R s 1 , 2 3 , 1 7 1 . 2 6 (Rs1,01,171.26+ Rs22,000). This means you get absolute return of 23.17% and annualized return of 7.72% without indexation benefit.

Let’s now consider the return on your investment if you calculate tax using indexation by taking CII figures for 2010-11 (711) and 2012-13 (852). Your capital gains on investment in FMP is Rs23,602.32 while the total pre-tax amount on FMP is Rs1,03,602.3. However, the inflation-adjusted investment amount (using indexation formula) comes to Rs95864.98 (80,000*852/711) taking the net capital gains on FMP to Rs7,737.34 (Rs1,03,602.32- Rs95,864.96).

If you calculate 20.60% tax with indexation on this capital gains of Rs7737.34, your tax outgo on capital gains with indexation would be Rs 1593.89, taking the post-tax amount on FMP to Rs1,02,008.43 (Rs1,03,602.32-Rs1593.89).

Now even if your equity return gives an absolute negative return of 10% over three years (Rs18,000) your total post tax amount at the end of 3 years would be Rs1,20,008.43 (Rs102008.43+Rs18000), getting you absolute return of 20.01% and annualized return of 6.67%.

The Downside

One of the biggest drawbacks of capital protection funds is that they are listed on stock exchange as they are close-ended schemes. This means the only way to come out of these funds in the interim is by selling them on an exchange. But selling may not be a profitable way to exit simply because most of these funds are illiquid and there is a dearth of buyers for such funds on the exchange, forcing sellers to sell funds at a discount.

Another disadvantage of capital protection funds is that these are taxed in the same way as debt funds. Since these funds invest less than 65% in equity, they come under debt taxation structure wherein the long term capital gains are taxed at 10.30% without indexation and 20.60% with indexation.

It is however important to mention that you’ll get indexation advantage over long term capital gains in case of investment in FMP or any debt schemes of mutual funds only. If you invest in fixed deposits instead of debt instruments, the interest income is added under the head of income from other sources and is taxed according to individual’s tax bracket. Also, if you opt for a cumulative option under any NCD (Non Convertible Debenture) or sell it on exchange after one year, still indexation benefit may not be applicable and the long term capital gains will be taxed at flat 10.30% without indexation.

However, it is important for you as an investor to understand that unlike openended debt funds where you can redeem as and when you want, FMPs or NCDs are sold on an exchange. However, if sold before one year they will attract short term capital gains taxed as per the tax slab of the investor. This may lead to liquidity risk for the investor.

Are You Upto it?

Capital protection funds provide a ready mix of portfolio and if this suits your risk appetite, you may opt for it. These funds do not have very high expense ratio which is in line with most MIPs. Besides it can be a good and attractive investment option for all those who prefer capital safety first.

Last but not the least, it may not be practical for everyone to create and manage his/her own portfolio and pick right products for the portfolio mix. If you are planning for something like this, consider taking advice from a financial advisor.