Capital protection funds: What are they and how do they fare against fixed deposits?
Protected funds much benefit a risk-aversive investor not in need of major returns
A protected fund, or a capital protection fund, is a type of mutual fund that promises to return at least some portion of the initial investment to an investor.
By investing in such a fund the protected initial investment, plus some capital gain, will be returned as long as the investor holds the original investment until the end of the contractual term.
A protected fund, or a capital protection fund, is a type of mutual fund that promises to return at least some portion of the initial investment to an investor.
Because the fund is able to invest in the stock market the investor is exposed to market returns, but the main idea behind this type of fund is that you will have the safety of the guaranteed principal amount.
So, the investor’s capital is safeguarded in the event of market downturns while simultaneously providing them scope for capital appreciation by participating in upturns of the equity market.
The capital protection orientation of the fund means that the debt component will be managed in such a manner that the returns from it increase to the level of initial capital invested.
At the same time, the equity portion of the portfolio is managed with the aim to provide a boost to the overall portfolio value.
The remaining 15 per cent comprising equity is managed to generate an upside to the portfolio. The portfolio is normally invested in highest grade debt instruments.
Key takeaway points
• The portfolio comprises of a mix of equity and debt, typically of the nature of a hybrid fund
Initial capital benefits from possible market gains, but is safeguarded in the event of market downturns
• The initial investment can only be paid back after the guarantee period is over
• Portfolio is normally invested in highest grade debt instruments, improving defensiveness
Key disadvantages when investing in capital protected funds
It is heavily oriented towards debt (especially zero coupon debt) and only a small part of the portfolio is invested in equity.
Capital protected funds are heavily oriented towards debt and only a small part of the portfolio is invested in equity.
These funds provide superior downside risk protection during a market downturn but offer limited upside during market upturns.
They are suitable for conservative investors with a low risk appetite.
These funds provide even the most conservative investors an opportunity to invest a small part of their portfolio in equity, thereby giving them the scope to participate in equity market upturns.
So, subsequent purchase and sale of units is possible only on the exchange platform, where the fund is listed. But this is difficult as secondary market deals can often become a mammoth task in the absence of sufficient liquidity.
The portfolio manager will often purchase an additional insurance policy to protect the principal, the cost of which is passed on to the investor. In countries like India, however, the capital protection is not guaranteed.
If the investor sells before the contractual period ends, he or she is subject to any losses as well as possible fees for early redemption. This type of fund tends to have higher expense ratios than other types of mutual funds.
Such debt-dominant funds are the closest when it comes to conventional FDs in terms of risk, with the fund’s primary goal to give investors steady income throughout the investment horizon.
Banks offer a pre-set interest rate for fixed deposits based on the tenure chosen. A protected fund returns, to a great extent, depends on the overall interest rate movement.
Protected funds has relatively better returns
The debt oriented funds might generate moderate returns (relatively more than fixed deposits) in the form of capital appreciation and regular income.
One perk about fixed deposits is that market highs and lows will not impact the returns you earn. But typically, debt funds outdo fixed deposits by a considerable margin during times of low interest rates in the economy.
Debt oriented funds might generate moderate returns - relatively more than fixed deposits!
When it comes to taxation in India, as for fixed deposit returns, the gains will be taxed as per your tax slabs.
Short-term gains (i.e. less than three years) on protected funds are taxable as per your tax slab rate. (The taxation rules on capital protection funds are same as those applicable on debt funds.)
How taxes apply to FDs, protected funds?
Long-term gains (i.e. up to three years or more) on debt funds are taxable at 20 per cent with the benefit of indexation.
Debt skewed mutual funds, albeit the risk, have the potential to pace with inflation.
For instance, you have invested in an FD at 6 per cent interest and the inflation rate is 5 per cent, the adjusted return would be a merely 1 per cent. Protected funds may deliver relatively higher returns.
Debt skewed mutual funds, albeit the risk, have the potential to pace with inflation.
Important to note that in India, after demonetization, many banks lowered the FD rates due to excessive liquidity.
State Bank of India (SBI), for example, currently offers 6.9 per cent for 1-year deposits, compared to 8 per cent in 2015.
In India, after demonetization, many banks lowered the FD rates due to excessive liquidity.
For a 3 year deposit, it is even lower at 6.60 per cent. Debt funds have historically given returns in the range of 7-9 per cent per annum.
The reason being guarantees on all bank deposits above a certain amount, up to INR100,000 (Dh4,870) in India, in the event of your bank’s failure.
Although debt funds or debt-dominant funds are relatively less risky than equity funds, they are not risk-free like the way bank FDs are.
By investing in government securities, money market instruments, and corporate deposits, investors are generally still exposed to the risk of default or bankruptcy of concerned parties.
In this aspect, protected funds are a tad riskier as compared to traditional fixed deposits.
To the ordinary investor, structured notes seem to make perfect sense.
Investment banks advertise structured notes as the ideal vehicle to help you benefit from excellent stock market performance while simultaneously protecting you from bad market performance.
Capital protected structured notes: Risks and Perks!
Investment banks also often advertise that structured notes allow you to access asset classes that are only available to institutions or hard for the average investor to access.
But investing in a complex package of derivatives (structured notes) is not widely seen as easy to access.
Besides, these days it’s easy to invest in almost anything via mutual funds, exchange-traded funds (ETFs), exchange-traded notes (ETNs), and more.
Banks also don't reveal that the cost of that protection usually outweighs the benefits.
A major disadvantage of structured notes is that the investor must undertake significant credit risk in the event the issuing investment bank forfeits its obligations, as was the case with the collapse of Lehman Brothers in 2008.
Call risk, lack of liquidity, and inaccurate pricing are other disadvantages of structured notes.
Structured notes rarely trade on the secondary market after issuance, which means they are punishingly illiquid. Also, because of which the odds of accurate daily pricing are very low.
For some structured notes, it’s possible for the issuer to redeem the note before maturity, regardless of the price.
This also means it’s possible that an investor will be forced to receive a price that’s well below face value.