What are Capital Protection Funds?

If you are looking for an investment option that provides equity-like returns with FD-like protection, capital protection funds could be a good bet for you. We have covered the following in this article: This article covers the following:

The primary objective of capital protection funds is to safeguard the interest of the investors during economic downturns and at the same time, preserve their capital. Given the nature of these funds, they substantially minimise the risk of capital loss with the significant chunk of the amount invested in AAA-rated bonds which have only a minimal chance of defaulting.

Introduction

The portfolio of capital protection funds consists of a mix of equity and debt, where the major investment is made in debt, particularly zero-coupon debt, and only a small fraction of the portfolio is invested in equities. The maturity of the debt portfolio and the lock-in period of the funds are aligned, which further protects it from volatile interest rate movements.

The chances of interest rate fluctuation related market-to-market losses are also averted as these debt instruments are held till the time of maturity. These are close-ended funds with a term usually between 1, 3 and 5 years, offering a conservative investment option.

Where do capital protection funds invest?

As the name suggests, capital protection funds invest meticulously in fixed income options and equity. These are closed-ended hybrid mutual fund schemes with a clear focus on debt to achieve capital protection. Typically, the allocation between equity and debt is based on the bond yield and the term of the scheme.

A significant portion of the corpus is invested in high-rated fixed-income securities to earn assured returns, and the rest of the money is invested in equity to earn additional returns. The capital protection orientation of the fund means that the debt component of the fund is managed in a way that the returns from it increase to match the level of the amount of the initial capital that was invested.    

Capital protection funds typically invest a major share, about 80% of the total investment amount into highly secure debt instruments like AAA-rated bonds. The remaining 20% of the amount is invested in much riskier avenues like equity. The design of the fund thus protects the principal, regardless of how the equity market fares during economic downturns, the principal amount is protected.

Let’s understand with the help of an example. Suppose capital protection funds have an investment corpus of ₹10,000. It invests approximately ₹9,174 in debt instruments with a yield of 9% for one year. This ensures that the maturity value of the debt investment becomes ₹10,000. The remaining amount of ₹826 is invested in equity. At the end of the tenure, the capital remains intact, and the growth of the equity investment is the gain.

Why are Capital Protection Funds better than Fixed Deposits?

Capital protection funds are far better than FDs if the safety of capital is the primary objective. These funds tend to provide higher post-tax returns as compared to other pure fixed-income havens like fixed maturity plans.  

Who should Invest in Capital Protection Funds?

These hybrid funds are best suited for risk-averse, new or first-time investors and even those investors who have rigour investing in equity options separately on their own. Investing in capital protection funds is also a good way for you to garner experience in equity investing.

The downside of investing in capital protection funds is that the returns on these funds are capped and the lock-in period does not allow investors to exit before the maturity, unlike in the case of open-ended debt funds. Hence, it is ideal for investors who want to invest with a long-term perspective in mind. There is no room for capital appreciation with regards to fall in interest rates either.

Are Returns on Capital Protection Funds Guaranteed?

It is important to remember that capital protection is not guaranteed. Debt instruments like government bonds, bank fixed deposits and post office savings guarantee returns based on an institutional cover. On the other hand, these schemes offer protection of capital by structuring the portfolio optimally.

How do I choose a Capital Protection Fund?

Choosing a scheme should be based on your investment objectives, risk appetite, and liquidity requirement. Keep the following aspects in mind before opting for a capital protection fund:

• Go through the investment objective thoroughly to ensure that the scheme intends to invest as desired by you
• Credit Rating Information Services of India Limited (CRISIL) rates capital protection-oriented schemes based on the probability of the portfolio value falling below the initially contracted principal value and/or investors getting their money back in full. Check the CRISIL rating or the particular scheme
• The tenure of the scheme should match your investment horizon
• The most important aspect is the asset allocation. Read the offer document carefully to understand the risks that the fund manager might take to enhance returns

Remember, return on investments are directly proportional to the risks involved. Higher the risk – higher the return and vice versa. The objective of a Capital Protection Oriented Fund is to protect your capital while allowing you to earn returns by investing a part of the corpus in equity.

Look for schemes that have this investment objective clear. If unsure, reach out to one of our financial experts at ClearTax today to find the right scheme that fits your profile.