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Add Equity flavour without Capital at Risk!
November 26, 2010

In this article, we explain to investors the benefits of investing in a capital protection mutual fund.

Author : Nikhil Kothari

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Capital Protection - New Fund Type

Capital Protection fund is a close-ended hybrid mutual fund that invests in a mix of equity and fixed income papers. The fund invests passively in highly rated fixed income papers of duration  in line with maturity of the scheme and the final maturity value of fixed income investments is equal to or greater than the principal of the scheme. This ensures that on maturity, the money invested in fixed income instruments grows to match the original principal of the scheme and hence, the capital is guaranteed. The rest of the money is invested in equities so as to enhance the return of the portfolio.

These schemes work on the philosophy that even if the return from equity portion of the portfolio is negative 100%, the capital is protected and the investor would receive the initial value on maturity. However, the capital is guaranteed only if investor remains invested in the scheme till the end.

The performance of capital guaranteed scheme depends on the performance of the equity component of the scheme i.e., the fund manager’s ability to select stocks. In the past, few capital guaranteed scheme were also launched wherein the equity portion of the portfolio would be invested in Nifty ETF, but in this case, the performance depended on the overall performance of the index not on the fund management skill-set.

In terms of taxation, capital guaranteed schemes are more tax efficient than fixed deposit as the former gets treated as a debt mutual fund instrument. If held more than a year the investor would pay 10% (without indexation) and 20% (with indexation); whereas fixed deposits are taxed as per the marginal tax bracket (30% in case of highest tax bracket).

Illustration of Capital Guaranteed Scheme

For e. g., a 3 year capital guaranteed scheme is launched with portfolio value of INR 1 crore. Let’s assume, that return generated by portfolio of 3 year AAA rated corporate paper and government securities is 8%.

Table 1

Capital Protection Fund
Fixed Deposits
Fixed Maturity Plans
Scenerio : 1
Scenerio : 2
Scenerio : 3
Beginning Portfolio Value INR 10,000,000 INR 10,000,000 INR 10,000,000 INR 10,000,000 INR 10,000,000
Initial Invested in Debt INR 7,938,322.41 INR 7,938,322.41 INR 7,938,322.41 INR 10,000,000 INR 10,000,000
Initial Invested in Equities INR 2,061,677.59 INR 2,061,677.59 INR 2,061,677.59 NA NA
Expected Return on Debt - CAGR 8% 8% 8% 8% 8%
Expected Return on Equity - CAGR -10% 10% 20% NA NA
Maturity Value of Debt (after 3 years) INR 10,000,000.00 INR 10,000,000.00 INR 10,000,000.00 INR 12,597,120.00 INR 12,597,120.00
Maturity Value of Equity (after 3 years) INR 1,502,962.96 INR 2,744,092.87 INR 3,562,578.88 NA NA
Ending Portfolio Value INR 11,502,962.96 INR 12,744,092.87 INR 13,562,578.88 INR 12,597,120.00 INR 12,597,120.00
Expected Return (Pre Tax) 4.78% 8.42% 10.69% 8.00% 8.00%
Tax Rate 10.00% 10.00% 10.00% 30% 10%
Post Tax Portfolio Value INR 11,352,666.67 INR 12,469,683.58 INR 13,206,320.99 INR 11,817,984.00 INR 12,337,408.00
Post Tax Expected Return 4.32% 7.63% 9.71% 5.73% 7.25%
Source: iFAST Compilation

*We have not taken into account the expense structure in the above example but that would necessitate additional returns from the fixed income component.  So higher the expenses, more interest income would be needed to compensate for the expenses and vice versa.

In the above table, we have seen that return of the capital protection fund portfolio increases as the return on equity increases. The capital is guaranteed by amount invested in debt portfolio.

As compared to fixed deposits, post tax return generated by capital protection fund would be much higher as later is more tax efficient.

Our take on Capital Protection fund

We are of the view that the short-term rates are trading at attractive levels on account of tight liquidity condition and continuous rate hikes by Reserve Bank of India. The yield on short-term debt papers i.e., 1 year to 3 years have inched up quite a bit in the last few months. Hence, investment at current yield levels held till maturity will result in good accrual return (in the form of high coupons).

On equity side, markets were trading at all-time high recently, before the small correction which we have witnessed in the last few days. We believe that there could be some volatility in the short term however, we are quite positive on Indian equity market over 3 to 5 year time horizon. Indian markets would continue to remain an attractive investment destination for foreign investors for years to come and considering India’s domestic growth story, equity markets could deliver good returns over next few years.

In addition, India is world second fastest growing economy and is expected to grow above 8% for at least a decade. With a positive demographic and consumption story, the equity markets are well positioned as an attractive investment opportunity for long term. Hence to take advantage of current investment opportunities available in debt and equity markets, fund houses have started launching capital protection fund.

So, we believe that capital protection fund is appropriate for an investor with conservative to moderately conservative risk appetite.  These funds provide guarantee of capital with an avenue to participate in Indian equity markets. Hence, those investors who have less appetite to take risk with an intention to generate higher return by way of appreciation in equity market can look at investing in such mutual funds.

Individuals belonging to the highest tax bracket can invest some portion in capital protection funds as they are more tax efficient than fixed deposits and hence, can enhance their post tax return. Lastly, these funds at this juncture provide an opportunity to lock in money at attractive yields and invest the rest in the buoyant equity market of India.

Disclaimer: iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.Please read our disclaimer in the website.

Risk Factors: • Mutual funds, like securities investments, are subject to market risks and there is no guarantee against loss in the Scheme or that the Scheme’s objectives will be achieved. • As with any investment in securities, the NAV of the Units issued under the Scheme can go up or down depending on various factors and forces affecting capital markets. • Past performance of the Sponsor/the AMC/the Mutual Fund does not indicate the future performance of the Scheme. • The name of the Scheme does not in any manner indicate the quality of the Scheme, its future prospects or returns. • Please read the Statement of Additional Information and Scheme Information Document carefully before investing.

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