Capital Protection Products

by Gopal Gidwani on December 28, 2009 · 0 comments

in Fixed Income Securities,Uncategorized

Capital Protection Products
When the markets fell due to the subprime crisis lot of people saw most of their spectacular gains made in the last 1 or 2 years wiped out within months and infact they were staring at losses. Such was the shock and panic that investors started to give markets a complete miss. People started parking their hard earned money in conventional products like Bank Fixed Deposits and other Government sponsored schemes like Public Provident Fund (PPF), National Savings Certificates (NSC) and various Post Office Schemes etc.
Mutual Funds and Insurance companies started losing business as people became risk averse. People started shying away from the various equity schemes of mutual funds and unit linked insurance plans (ULIPs) of insurance companies. So these companies had to rework their business strategies and come out with innovative products so that they could get their customers back which were lost in the market crash. Some of the mutual funds and insurance companies started pushing their existing capital protection products aggressively. Companies that did not have capital protection products came out with these new products.

Concept of Capital Protection
Capital Protection Products (CPP) are also referred to as Capital Guarantee Schemes by some people. So what exactly are these capital protection products? Capital protection products / schemes are those which protect the capital i.e. the initial amount invested and do not guarantee returns.

How to set up a Capital Protection Portfolio?
In such products the portfolio is designed in such a way that a certain portion of the capital is invested in debt products (AAA rated) which on maturity equals the initial capital.
For example let us assume Kartik invests Rs 100 in the Capital Protection Product of ABC Mutual Fund for 5 years. Let us assume that a debt instrument is offering 7% return. Then in this case ABC Mutual Fund will invest Rs 71.30 in the debt instrument. This amount will mature to Rs 100 in 5 years. In this way the capital is protected. So Kartik is assured of getting his initial investment of Rs 100 on maturity in the worst case scenario. The remaining amount Rs 28.7 (100 – 71.30) will be invested by Mutual Fund ABC in the equity market or other riskier assets to provide additional returns to Kartik. If the markets double in 5 years then this Rs 28.7 will also double to Rs 57.4. So in this case the total return the investor (Kartik in this case) will get on maturity is Rs 157.4 (Rs 100 + Rs 57.4). So this is an absolute return of 57.4% on the initial investment of Rs 100. This may be in the best case scenario. But there is also a chance of markets not doing well and the investor may end up losing this Rs 28.7. In the event of this happening in any case the investor will get back his Rs 100 on maturity. But then he does not earn any returns in this case. This may be the worst case scenario. So in this case the portfolio of Kartik has upward potential but the downside is protected to Rs 100.

Now let us assume that Kartik is smart enough and doesn’t approach Mutual Fund ABC. He decides to build his own investment portfolio. If the investor (Kartik) invests the entire Rs 100 in a debt instrument (Government Bond) at 7% on his own instead of going for a CPP, then the investor will get Rs 140.25 on maturity. This is as good as guaranteed return as the money is invested in a Government Bond. Also if the investor is investing for the long term and invests the entire money in the equity market on his own instead of going for a CPP, chances are he will earn a much higher return. So if the investor invests the entire Rs 100 in the equity market and the markets give a CAGR return of 15%, then the investor will have Rs 201 on maturity after 5 years. So when the investor directly invests the entire money in debt securities then in the worst case scenario he earns Rs 140.25. And if he invests the entire money in the equity market directly then in the best case scenario at 15% return he earns Rs 201. Both the returns are better than the above portfolio constructed under the Capital Protection Scheme.

Features of Capital Protection Products

  • Capital Protection: As per SEBI guidelines AMCs are not allowed to give any guarantee. But under the CPP the portfolio is structured in such a way that the investment in debt products on maturity matches the initial capital investment amount. This ensures the safety or protection of the capital.
  • Rating by Credit Agency: As per SEBI guidelines the CPP schemes have to get their portfolio rated by a SEBI registered credit agency. The portfolio also needs to be reviewed by the rating agency every quarter. The AMCs have to invest in debt instruments that have the highest investment rating of AAA.
  • Exit before Maturity: These are close ended schemes and exit / redemption before maturity is generally not allowed.
  • Charges: These products may charge annual fund management charges and other charges.
  • Taxability: Capital Protection Plans are charged at 10% as long term capital gains (LTCG).

While Capital Protection Plans do protect the investor’s capital they don’t come with any guaranteed returns. Investors can also replicate the CPPs and construct their own portfolio to suit their requirements. But before doing this the investor has to do his homework well. People who don’t understand investment products very well should at best leave it to mutual funds or insurance companies to design their portfolio as they have the required expertise for doing it.

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