Capital Protection Funds — A closed ended debt mutual fund

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Capital protection funds are back. ICICI Prudential Mutual Fund and Tata Mutual Fund have recently launched these schemes. These funds are coming at the right time when volatility is the order of the day on Dalal Street, and many investors are desperate to preserve their capital. Look at these numbers: S&P CNX Nifty returned 2.9% in the past five years, making investors revisit their assumptions of long-term investing. A weak rupee and the credit crisis in Europe have made it even more difficult to guess the future course of the market. This is where the capital protection schemes enter the scene. Capital protection oriented funds make good investment option in volatile markets. The fixed income portfolio ensures that investors get their money back at maturity and the equity allocation brings the return kicker.

How They Work?

Assume there is a three-year CPOF. The fund manager gets 8% interest per year on three-year AAA-rated papers. Around 80% of the money deployed in such AAA-rated papers ensures that investors get their money at the end of the third year, as interest on these investments accumulate. According to CRISIL default study 2011, from 1988 to 2011, no AAA-rated instrument defaulted over one-, two- or three-year period. This makes a strong case that the money comes back to investors at the end of the third year. Rest 20% of money is invested in equities. If over three years this investment appreciates 20%, the portfolio value becomes 124 (fixed income portfolio worth 100 plus equity portfolio of 24) over three years, a CAGR of 7.43%. If equity investment doubles over the three-year period, investors take home 40% point-to-point return, or a CAGR of 11.87%.

As the tenure of the scheme increases, allocation to equities also goes up as less money is required to ensure the capital at the end of the tenure, compared to a scheme with a shorter tenure.

But capital protection oriented funds have some disadvantages as well. Being a closed-ended scheme, it is listed on the stock exchange and there is little chance that you will get to exit at fair value because of the poor liquidity of most such products listed on the exchanges. The second big disadvantage is that these funds are taxed like debt mutual funds. Long term capital gains are taxed at 10.3% without indexation or 20.6% with indexation, whichever is lower. Also, according to mutual fund experts, the performance of these schemes has been a mixed bag. There are 45 capital protection oriented funds across 11 fund houses listed on the stock exchanges.