The risk that market-linked investment avenues (like mutual funds) pose to investors is erosion of capital. Any movement in the stock market is clearly reflected in the performance of an equity fund; the extent to which the fund responds to the movement however depends on various factors like the investment style and underlying investments made.
Adverse market conditions can make investors feel insecure about their investments, leading to distress redemptions (mostly at losses) or even worse it deters them from investing in such avenues. In such a scenario, anything that guarantees the protection of atleast the initial invested capital appears to be a good deal.
Recently, SEBI (Securities and Exchange Board of India) has given the go-ahead to mutual funds for the launch of Capital Protection Schemes (CPS). As the name suggests, investments in such schemes comes with a guarantee, albeit implicit, that the investor's capital will be safeguarded. Hence, irrespective of the direction in which the market moves or even if the scheme underperforms, the protection of the investor's capital is guaranteed by the AMC (Asset Management Company).
With SEBI giving its nod and formalising the regulations for such schemes, it could only be a matter of time before we see a plethora of CPS being launched by AMCs. Given that AMCs have a penchant for launching me-too products, like 5-Yr close-ended equity funds and 3-Yr close-ended debt funds (with moderate equity allocations) at present, such a reaction is only to be expected. Over here we explore the value-add that CPS can bring to the table for investors.
To begin with, investors should understand that CPS are not similar to assured return schemes (which are not permitted under SEBI guidelines). The difference between the two is that with CPS, the AMC assures the investor of protecting his initial capital investment and not the returns, which is the case with assured return schemes.
As per SEBI guidelines, CPS have to be close-ended in nature. Also investors investing in these schemes will not have an exit option before maturity. The close-ended structure will enable the fund manager to manage the portfolio with the benefit of a defined maturity i.e. no worries about redemptions and fresh inflows; for investors this is a good sign, but it also means blocking of funds. Investors should make sure that they invest only that portion of their capital, which they will not need in the near future.
Also, as a mandatory practice, the AMCs have to get the proposed portfolio structure (indicated in the offer document and key information memorandum) of the CPS rated by a SEBI-registered credit rating agency. This is done with the aim of assessing the degree of certainty for achieving the objective of capital protection. Also as per SEBI's guidelines, the rating should be reviewed on a quarterly basis and the AMC should ensure that the debt component of the portfolio structure has the highest investment grade rating (AAA, P1+ for instance). The investor will draw comfort from the rating knowing that the portfolio quality is under a constant watch.
As investors would have gauged, CPS are relatively low risk investment avenues that are designed to protect the capital under all market conditions. To achieve their objective, they invest either completely or significantly in highly rated debt instruments like corporate or government bonds among others. With this strategy, they attempt to prevent erosion of capital over the investment tenure. These funds can also invest, based on their investment mandate, a portion of their net assets in equities to generate capital appreciation.
In this respect, CPS draw from Fixed Maturity Plans (FMPs). FMPs, which are close-ended debt-oriented funds, invest in debt instruments and the yield is locked in till the maturity of the scheme to curtail interest rate risk. Some FMPs lock-in a portion of their assets (usually 80%-85%) in debt paper and invest the balance in equities. The objective is to achieve capital preservation through the debt portfolio and capital appreciation through equities.
In a way, CPSs also resemble monthly income plans (MIPs); MIPs invest mainly in debt instruments with the objective to safeguard capital and invest a smaller portion of their assets (ranging from 10% to 30%) in equities to generate growth and declare dividends.
Our view
To begin with, CPS go against the grain of mutual funds, which by nature are market-linked investments. In a market-linked investment, investors should not have to deal with terms like capital protection and capital guarantee. Those are terms from the assured returns/fixed income segment and even fixed income products like fixed deposit investors (in some corporative banks for instance) have been known to forfeit the entire capital. So investors should be willing to take on risk even if moderately, rather than to expect capital protection from a market-linked investment. In a way, this is a regressive step.
Having spoken to some AMCs, there is not a great deal of clarity on how the capital guarantee clause will come into effect if there is loss of capital. Apparently, SEBI's regulations on CPS are open to various interpretations.
CPS are particularly attractive during a high interest rate regime when locking the yield at a higher level makes sense. For instance, two years ago (August 2004) the 10-Yr Government of India (GOI) was hovering at a yield just over 6.00%. A 3-Yr CPS (maturing in August 2007) launched then would have looked extremely unattractive under the present scenario when the 10-Yr yield has climbed as high as 8.45%. In effect, investors have taken on interest rate risk without realising it. So CPSs are 'seasonal' and investors will have to do some homework to understand if it is the right time to lock-in yields.
In terms of tax efficiency, investors in the higher tax brackets could be better off investing in CPS as opposed to FDs. CPS being debt funds have their dividends taxed at 14.03%, while FDs are taxed at the marginal rate of tax.
CPSs can serve as a good transition product for low risk investors who are primarily exposed to FDs and small saving schemes like Public Provident Fund (PPF) and National Saving Certificate (NSC). This class of investors who have shunned mutual funds so far because of their market-linked nature can migrate to a 'soft investment' like a CPS. For a free download of the latest issue of Money Simplified - The definitive guide to planning for your child's future, Click here! 
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