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Add Equity flavour without Capital at Risk!

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  • 1. Add Equity flavour without Capital at Risk! Author: Nikhil Kothari, Research Analyst, iFAST Financial India Pvt. Ltd. In this article, we explain to investors the benefits of investing in a capital protection mutual fund. Capital Protection - New Fund Type Capital Protection fund is a close-ended hybrid mutual fund that invests in a mix of equity and fixed income papers. The fund invests passively in highly rated fixed income papers of duration in line with maturity of the scheme and the final maturity value of fixed income investments is equal to or greater than the principal of the scheme. This ensures that on maturity, the money invested in fixed income instruments grows to match the original principal of the scheme and hence, the capital is guaranteed. The rest of the money is invested in equities so as to enhance the return of the portfolio. These schemes work on the philosophy that even if the return from equity portion of the portfolio is - 100%, the capital is protected and the investor would receive the initial value on maturity. However, the capital is guaranteed only if investor remains invested in the scheme till the end. The performance of capital guaranteed scheme depends on the performance of the equity component of the scheme i.e., the fund manager’s ability to select stocks. In the past, few capital guaranteed scheme were also launched wherein the equity portion of the portfolio would be invested in Nifty ETF, but in this case, the performance depended on the overall performance of the index not on the fund management skill-set. In terms of taxation, capital guaranteed schemes are more tax efficient than fixed deposit as the former gets treated as a debt mutual fund instrument. If held more than a year the investor would pay 10% (without indexation) and 20% (with indexation); whereas fixed deposits are taxed as per the marginal tax bracket (30% in case of highest tax bracket). Illustration of Capital Guaranteed Scheme For e. g., a 3 year capital guaranteed scheme is launched with portfolio value of INR 1 crore. Let’s assume, that return generated by portfolio of 3 year AAA rated corporate paper and government securities is 8%. Table 1
  • 2. *We have not taken into account the expense structure in the above example but that would necessitate additional returns from the fixed income component. So higher the expenses, more interest income would be needed to compensate for the expenses and vice versa. In the above table, we have seen that return of the capital protection fund portfolio increases as the return on equity increases. The capital is guaranteed by amount invested in debt portfolio. As compared to fixed deposits, post tax return generated by capital protection fund would be much higher as later is more tax efficient. Our take on Capital Protection fund: We are of the view that the short-term rates are trading at attractive levels on account of tight liquidity condition and continuous rate hikes by Reserve Bank of India. The yield on short-term debt papers i.e., 1 year to 3 years have inched up quite a bit in the last few months. Hence, investment at current yield levels held till maturity will result in good accrual return (in the form of high coupons). On equity side, markets were trading at all-time high recently, before the small correction which we have witnessed in the last few days. We believe that there could be some volatility in the short term however, we are quite positive on Indian equity market over 3 to 5 year time horizon. Indian markets would continue to remain an attractive investment destination for foreign investors for years to come and considering India’s domestic growth story, equity markets could deliver good returns over next few years. In addition, India is world second fastest growing economy and is expected to grow above 8% for at least a decade. With a positive demographic and consumption story, the equity markets are well positioned as an attractive investment opportunity for long term. Hence to take advantage of current investment opportunities available in debt and equity markets, fund houses have started launching capital protection fund.
  • 3. So, we believe that capital protection fund is appropriate for an investor with conservative to moderately conservative risk appetite. These funds provide guarantee of capital with an avenue to participate in Indian equity markets. Hence, those investors who have less appetite to take risk with an intention to generate higher return by way of appreciation in equity market can look at investing in such mutual funds. Individuals belonging to the highest tax bracket can invest some portion in capital protection funds as they are more tax efficient than fixed deposits and hence, can enhance their post tax return. Lastly, these funds at this juncture provide an opportunity to lock in money at attractive yields and invest the rest in the buoyant equity market of India. Sundaram Capital Protection Oriented Fund Series II – 3 years: Sundaram Mutual Fund has launched a 3 year capital protection oriented fund Series 2. The fund would invest over 80% of corpus in AAA rated corporate paper or government securities and would hold them till maturity so that with interest, the fund grows back to principal investment. And rest of the money, around 20%, would be invested in equities. The equity portion would be invested in stocks forming part of S&P CNX 500 index. The portfolio will be a multi-cap equity portfolio with a mid and small-cap emphasis. The fund is rated AAA (Structured Obligation) by CRISIL indicating the highest degree of certainty regarding timely payment of face value of the investment. Sundaram Capital Protection Oriented fund Series 1 (3 year) was launched in 9 July 2007. The fund gave a return of 8.90% as compared to 7.74% by the scheme benchmark. Basic details of Sundaram Capital Protection Fund Series 2: Scheme Sundaram Capital Protection Oriented Fund Series 2 - 3 years Nature of the Scheme Closes Ended Debt Fund NFO Opens 22-Nov-10 NFO Closes 30-Nov-10 Minimum Investment Amount INR 5000 Benchmark CRISIL MIP Blended Index Listing NSE Entry Load Nil Exit Load Nil Fund Manager Dwijendra Srivastava( Fixed Income Component) & S. Krishna Kumar (Equity Component)
  • 4. Disclaimer This article is for information purpose only. This article and information do not constitute a distribution, an endorsement, an investment advice, an offer to buy or sell or the solicitation of an offer to buy or sell any securities/schemes or any other financial products /investment products mentioned in this article or an attempt to influence the opinion or behaviour of the investors /recipients. Any use of the information /any investment and investment related decisions of the investors/recipients are at their sole discretion and risk. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Opinions expressed herein are subject to change without notice.