It is by now a cliched statement that the Indian economy has cooled from its spectacular growth run over the last 3-4 years. With significant growth slowdown, inflation, high interest rate and general election related concerns looming over the economy, equity and debt markets have been weak and volatile. Some investors have gone for the ‘Cash Is King’ philosophy – preferring to wait through the current crisis. However, there are others who do not want to miss out on the rebound – as and when it occurs, but are still as uncertain about the economy as the other set. It is to cater to this (fairly large) set of people that several financial companies have launched capital protection schemes.

Capital Protection schemes are designed to provide part or whole equity upside, while keeping principal protected in case the markets go further down in the investment horizon. They are typically 3-5 year close ended schemes with minimum investment cut-offs ranging from Rs. 10 lakh to Rs. 1 crore.

All legal issues apart (for instance SEBI insisting on a particular semantics, or any reference to ‘capital protection’ coming with a long explanatory footnote), it is important to actually understand the risks and potential upsides to decide about investing in them. Obviously, the product presentation itself is a wrong place to start – as it often reads more like a lottery freebie being distributed, than like a dispassionate analysis.

We look at the non-derivative based capital protection schemes in this article. There are others that use F&O – which have a different style of working, are subject to very different risks and reward potential.

Capital ‘Protection’
The first point to note is that the capital protection afforded is in nominal terms – you would still have suffered loss of value in the interim due to inflation. For instance, even if you had put away Rs. 1 lakh in a fixed deposit for three years, it would have fetched you about Rs. 25,000 in interest over this period. On the other hand, the capital ‘protection’ that is accorded is only on the Rs. 1 lakh you had put in. Moreover, sometimes, loads and expenses are excluded from this capital protection – it is important to read the fine print of what are the exclusions, if any.

The second caveat is fairly common sense in hindsight, but is often overlooked by the investor. If a company X is guaranteeing you capital protection, you are obviously still having the risk of X itself going down in the interim. Now, this risk would have appeared far-fetched just a year ago, as the guarantee is typically offered by big names in the financial space. But now even the biggest names like Citigroup, UBS and Lehman Brothers have seen significant strain on their liquidity and solvency, so it’s no longer a one-way street. It is important to read the terms of the guarantee and be comfortable with the agent providing the guarantee.

The Equity Upside
Most schemes have equity upside ranging from 60% to 150% of the benchmark (say the Nifty). Here again it is important to read the scheme fine-print in terms of whether the upside is capped, and if so, at what level. Also, in considering the benchmark performance, several schemes have a complicated calculation – where they try to maximise the benchmark noting at entry, and minimise the noting at exit (as this makes their payout to the investor the minimum).

For example, the entry-point benchmark may be the highest point of Nifty in the first three months of scheme beginning; and the exit-point benchmark may be the lowest point in the last month. This effectively means that you are losing out on any gains in the first three months, and are also at a risk of loss occurring in the last month. These details would be given in the product presentation – it is important to read them and take cognizance.

Scheme Working
In a nutshell, the scheme invests enough in debt to be confident of getting the principal back, and invests the remaining money in equity.

Let’s say your total investment is Rs. 1 lakh, which is what you want back guaranteed in three years time. If the yield on a three-year government bond is 8%, one can keep aside Rs 75,000 in the bond and invest the remaining money in equity. Even if the remaining money were to be entirely lost, you would still get your capital back. And obviously, if equity does well, this investment can grow several-fold. This is the most rudimentary of capital protection schemes – one that you can design at home yourself (and save paying the management fees and loads).

Now, a fund can be more sophisticated about this. For instance, the entire Rs 25,000 in equity is unlikely to evaporate – and certainly not in a single day! Your risk of loss in a single day in equity is, say, only 10% of the investment. Thus, your equity allocation in the original portfolio can be actually much higher, while still having the option to get principal back. You could invest Rs 90,000 in equity and Rs 10,000 in debt – and switch completely to debt the next day if things go wrong. As long as markets don’t fall by greater than 10% in a given day, and you react fast enough, you would still be safe.

This is exactly the principle the schemes use - decrease equity exposure as markets fall, and increase it as markets rise. They have well defined limits and algorithms to decide the exact quantity of exposure. This typically works well, barring very extreme and sharp market movements. One other factor to note here is that by the design of the algorithm, the scheme typically misses out on upside if the market sharply rallies after a prolonged bear phase. This is because it takes time for the algorithm to ramp up equity exposure, by which time markets are already high.

The Last Word
In summary, there is a fair amount of complexity and sophistication involved in designing capital protection schemes. While you as an investor need not get into the actual mathematics behind it, it is nonetheless important that you go through the fine-print very carefully, especially in relation to the common caveats mentioned above. And finally, it is important to recognise that this is not as risk-free as government paper – so do not put your entire savings here!

- Ramganesh Iyer

The author works with PARK Financial Advisors Pvt. Ltd., Mumbai. He may be contacted at info@parkfa.com.

For more Views by Experts click here