Capital Protection Funds - Meaning,Features and Who Should Invest

Capital protection as a concept has a lot of appeal for conservative investors as the focus is entirely on being conservative and protecting your capital from too much depletion. However, the core purpose of investing is to earn returns that is able to beat inflation and leave some return on investment to enjoy. A good compromise formula can be the capital protection Oriented Schemes (CPOS).

As the very name suggests, the Capital Protection Oriented Schemes (CPOS) are oriented or tilted more towards capital protection. However, the caveat to remember is that these are not guaranteed return schemes and hence there is an element of risk involved in such schemes. The towards capital protection tilt emanates from the structure of their portfolios and no other factor. Let us take a quick look at the entire concept of capital protection schemes or CPOS and its benefits and implications.

What is the entire idea of a capital protection scheme or CPOS?

CPOS are normally close-ended hybrid schemes. That means, the schemes will not be available for daily purchase and sale at NAV based price. That is only in the case of open ended funds. Being a closed ended fund, such CPOS schemes are normally listed on the bourses. As the name suggests (capital protection), such CPOS funds are largely invested in debt. In fact, the benchmark for such CPOS funds is to invest around 80% of the total corpus in debt and other money market instruments and only the balance in equity.

What would be the tenure of a CPO?

A typical CPO fund will have a tenure of around 3 to 5 years. However, these are closed ended funds so go for CPO funds if you can really afford to lock in these funds for a period of 3-5 years. Otherwise, it is quite risky. It is true that such funds are listed on the stock exchanges but that is more of a theoretical advantage. Most of the CPOS are either traded very thinly on the stock exchanges or they are traded at prices that are divorced from the NAV. Either ways, it does not serve your purpose.

Of course, the advantage of being closed ended is that the fund manager does not have to worry about redemption pressures and hence can take a longer term perspective on the equity and debt front. SEBI stipulates that any CPOS fund must have at least 80% of their corpus in debt instruments. Additionally, SEBI also stipulates that the debt component must grow to the initial investment so that capital is protected fully. It also mandates that investments in debt must only be in instruments with the highest rating and the CPOS itself must be rated by a recognized national level rating agency.

How does capital protection work in the case of CPOS fund?

As we stated earlier, SEBI insists that the primary focus must be on capital protection. Hence the basic rule is that the debt component must grow to the principal amount. In a CPOS, allocation of the corpus to debt is done in a manner such that at the time of maturity the debt investment in the fund grows to the original investment in the portfolio. The equity component only enhances the returns of the CPOS to a more attractive level.

In our example below we envisage 3 scenarios of debt yields at 6%, 7% and 8%. In each of the scenarios, we assume the capital is fully protected. So, the debt investment is based on the yield and the balance is in equity. In each of the cases, the debt amount grows to Rs.100 so capital is protected.

In the above 3 scenarios, we have looked at a conservative, modest and aggressive debt market scenario. For equity, we have considered index fund returns of 17% CAGR over the last five years as a benchmark yield on equity. Based on the 3 scenarios, we have also estimated the CAGR returns from the CPOS fund.

In the above scenario, 8% debt returns would typically mean that the investors takes on more risk, which is against the basic rule of CPOS funds. Hence it is essential to be cautious and project a conservative return of around 6-7% on debt in best case scenario.

Advantages of investing in CPOS funds

Here are some of the major advantages of investing in a CPOS fund for an investor.

• The capital protection funds are extremely suited to investors who are generally spooked by the volatility in stock markets.
• CPOs ensures that the capital is protected but at the same time, the much needed alpha is provided by the equity component in the portfolio.
• Being closed ended, the CPOS normally do not have to worry about redemption pressures and can take a longer term view of capital protection.
• The investor gets the best of both worlds as they earn stable returns from the 80% allocation to debt while the equity component ensures alpha.
• If equity markets are on a rise in three to five years you could see your investments grow well.
• However, even if the equity markets see negative returns, capital is still protected and that is a big consolation to the investor.

When is capital protection fund a good choice?

You can choose a CPOS in any of the following scenarios:

• When markets are volatile and inflation level is under control. This ensures that you protect capital in volatility but inflation does not reduce real returns too much.
• When your investment horizon matches the CPOS tenure. For example, if you have a payable of Rs.100 payable after 3 years, then a 3 year CPOS is the ideal choice.
• When you do not have the appetite for interest rate volatility risk and want a degree of stable returns even if there is a lock in period.
• When you intend to participate in equities but do not want the associated risks, so CPOS provides equity participation with capital protection.
• CPOS can also be more tax efficient compared to bank FDs. If you opt for the growth scheme, then after the 3 year lock in, you earn long term capital gains, which is taxed at a concessional rate of 20% tax. However, since indexation benefit is also available, the effect incidence of tax is much lower. This also makes the proposition extremely tax efficient.

To sum it up, capital protection funds are a good fit for people who have defined financial goals and want to lock part of their corpus for a period of 3 to 5 years. In the interim, CPOS will ensure that you do not lose out on the equity advantage of alpha too. However, while capital protection is the goal, returns are not guaranteed.