Who needs a capital protection fund?

Of the products that the mutual fund industry likes to spring on investors at regular intervals, capital protection funds are surely the strangest. What else would you call a fund whose main objective is to “seek protection of capital by investing in debt and equity instruments”.

Why not bank deposits?

No investor likes to lose part of his capital to debt or equity market swings. But does that mean that protecting capital becomes a key investment objective for which he is required to pay a management fee? Why should safety of capital be a selling point at all in a country where banks do a splendid job of capital protection while serving up double-digit returns? If safety is one's priority, all one needs to do is invest less than Rs 1 lakh each in several bank deposits (to avail of deposit insurance).

Imperfect structure

Then there is the fact that capital protection products have structural problems. For one, most of these funds use a combination of debt and equity to deliver the promised capital protection. An 85:15 mix of debt and equity, for instance, makes sure that, even if the equity portion sinks without a trace, the interest earned on the debt portion can salvage your capital at maturity.

More complex capital protection structures (specially made for HNIs) use equity-linked notes or derivatives to deliver a certain “participation” in equity market upside while preserving your capital.

The problem with such products is that if the stock market were to soar tomorrow, I as an investor would like to benefit fully from that move. Assuming that stock markets climb at the expected rate of 15 per cent a year, what would I do with a 50 per cent “participation” in that?

Equity portion

Two, the short tenures of many of the capital protection products in the market also make them a less than ideal way to own equities. A five-year fund may be able to deliver reasonable returns from stocks. But given that bear markets in India are all too frequent, how can a fund with a term of just two years or three years hope to deliver on equity investments?

The product's closed end nature also exposes the investor to the risks of adverse timing at the time of investment, especially on the equity portion. Why should one take this risk, when there are systematic investment plans on other funds that allow you to phase out your equity investments?

Locked in

Three, the closed-end nature of capital protection funds also does away with one of the most attractive features of mutual fund investing – that of providing liquidity. But capital protection funds lock in your money for a fixed term. Though they are compulsorily listed on the exchanges, units of such funds are very thinly traded. A disappointed investor would hardly be able to exit the fund at a good price through the secondary market route. Given that they are closed end, information on capital protection funds is also not too easy to come by, whether it is on the portfolio or track record.

Overall, an investor who is paranoid about safety of his capital shouldn't stray anywhere near equities; he is better off with bank deposits. And an investor who can take a bit of risk and does not mind his portfolio going nowhere in three years, can get by quite well with a balanced fund or a monthly income plan.

There he gets to choose from a bouquet of funds with a three year track record. What is more, as these funds are open-ended, an investor can exit the fund midway if he is losing capital or is unhappy with its returns.

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