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Should I put my money in Capital Protection Funds?

Published on Mon, Jan 15, 2007 at 13:05 | Source : Moneycontrol.com

Updated at Mon, Jan 15, 2007 at 13:19

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Time and again, we come across a flurry of funds with similar themes. They are what can be termed as the flavour of the season. Though, of course, this 'craze of the season' phenomenon is not restricted to just mutual funds - it can be seen in fashion, movies, food, etc. Maybe, it has got to do something with the human nature!!

Anyway, coming back to the subject matter of this article - 'the Capital Protection Funds'- the latest trend in the mutual fund industry. (Also read - New Fund Offer: 5 points to note before you invest)

Let's understand what these are and whether we can bet our money on them.

Why Capital Protection Funds?
I spoke about human nature earlier. Well, the reason for emergence of Capital Protection Funds is again human nature. We hate to lose money (and many other things too). We want 'guaranteed' returns. We want 'assured' returns. We don't like taking risk.

And since equity does not offer 'guaranteed and assured returns' - in fact forget about returns, there are chances of losing the capital itself - we find only a miniscule of the investing population putting their money in equity. (Also read - Fears of a first time investor)

Well, nothing wrong with it. If someone doesn't want to take risk, its' perfectly fine! If someone is happy with modest returns, its' quite OK!

But to cater to this vast population, who don't want to risk losing everything in equity and yet want to enjoy some benefits of high returns from equity, the mutual fund industry has introduced the so-called 'Capital Protection Funds'.

As the name suggests, these funds will 'TRY' to protect our capital. Note that I have used the word 'TRY' and 'not guaranteed'. To repeat again - these funds will try and protect the capital but there is no guarantee. (Also read - Align your portfolio to your needs; not market needs)

Does that mean that the MF people are telling a lie? No. Definitely Not! They are all intelligent and honest people. They will definitely try and protect our capital. And most likely do it too. In all probability no one should lose money in these funds.

The question is - How? And from the answer to this question, we will get the answer to our basic question - Should we invest in Capital Protection Funds or not?

How will Capital Protection Funds protect our capital?
The MF people are not astrologers. They can't see the future. Yes, they will do research and all and invest our money in companies which are 'expected' to do well in the future. In fact that's all we can do. The future, as we have repeatedly seen, can however spring lots of surprises - both good and bad. Hence, they can't protect our capital by trying to read the future.

Nor are the MF people philanthropists, who will put in their own money in case the portfolio suffers a loss and pay you back at least your capital.

What they will do is actually very simple. Of the Rs.100 you invest, they will invest say about Rs.70-80 in debt. The balance about Rs.20-30 will go into equity. In 3-5 years (the usual tenure of these schemes), Rs.70-80 will appreciate to about Rs.100. Therefore, even if entire Rs.20-30 invested in equity is lost, you at least get back Rs.100. Hence, your capital is protected. (Also read - Mutual Fund resolutions one must follow in 2007)

In fact, if you have caught it by now, they are practically no different from the very familiar 'MIP' schemes. The only difference is that these are close-ended funds and hence get time to grow their debt portfolio from Rs.70-80 to Rs.100 and also give the much-needed 'time' to the equity component to prosper.

Of course, MFs may use sophisticated tools to decide on the right mix of debt and equity from time to time.

So, is there is a catch?
Well, there is no 'catch' in the negative sense. But yes, there is one issue - the returns. If, like most people, you assume that you can expect 40-50% equity-like returns, while at the same time protecting you capital, then you are wrong. Remember, there's no free lunch. (Also read - Smart strategies for volatile markets)

The returns from such funds will be limited. Assuming that equity gives around 30% returns p.a. over the next 3 years (this of course is matter of separate discussion, but 30% is a bit ambitious), then your Rs.20 would have become Rs.44. At the same time, Rs.80 in debt would have become Rs.100 (@8% p.a.). Thus, your Rs.100 would have appreciated to Rs.144 in 3 years, i.e. about 13% returns p.a.

Therefore, don't be misled by people, who may promise you the moon from such funds along with capital safety.

Is it worth putting your money in these funds?
As usual, it depends!

You now know what to expect from the Capital Protection Funds

Safety of your investment, but note there is 'no guarantee' in the legal sense
Somewhat better returns than debt funds, bank FDs, NSC, PPF etc. but definitely not the same as equity
3-5 years' lock-in as all these will be close-ended funds

If this is what you want from your investment, then go ahead and invest.

But if you want to enjoy the returns of equity, you got to take risks. These funds will not meet your high return expectations.

- Sanjay Matai

The author is an investment advisor and can be reached at sanjay.matai@moneycontrol.com.

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