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Mutual Funds - Should you switch to capital protection funds now?

28-May-2012

>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," says Chaitanya Pande, head- fixed income, ICICI Prudential AMC, explaining the rationale behind the schemes.

How they work

A capital protection oriented fund (CPOF) is a closed-ended debt mutual fund that aims to invest a significant amount of money in top-rated fixed income instruments and rest in equities. The tenure of the scheme can be one, three or five years. This investment along with the interest would ensure that the investor gets his capital back on maturity. The modest equity component is expected to be the icing on the cake. 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.

Should you invest?

"Markets have been range bound with downward bias for the past couple of years. Most of the negatives are already in the price. The attractive valuations of Indian equities make good investment case with a three-year view," says Abhinav Angirish, managing director, Investonline, an online mutual fund distribution entity. If you are keen on investing in stocks, but really worried about the downside risk, you can consider investing in a capital protection oriented fund. "These funds make sense for risk-averse investors looking for options to invest in equities, provided they are willing to remain invested throughout the term of the scheme," adds Abhinav Angirish.

The Downside

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," says Dhruva Raj Chatterji, senior research analyst at Morningstar India. 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.

Do it yourself

"If you do it yourself, you need not sacrifice liquidity all together and can bring down the tax impact, too," says a wealth manager. You can pick up a combination of three-year fixed maturity plan from a reputed fund house and an equity fund with good track record. Decide your extent of investment in the FMP by looking at the prevailing yields for that tenure and invest the rest in equities.

For example, in case of the three-year tenure, if the yield for the three-year paper is around 8%, you should put 80% of your corpus in FMP. For 7% and 9% the share of FMP should be 82% and 77% in your money. Rest of the money goes into an equity fund. Here the tax impact will be lower than CPOF, but money invested in the FMP won’t be liquid. If you are in the lowest tax bracket, you can also consider investing in a combination of a bank fixed deposit and an equity fund. But if you don’t have time to zero in on the right schemes and find mathematics difficult, opt for a CPOF.

Source : ET back

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