Understanding Capital Protection Scheme


By

Vivek Sharma
Faculty
Institute for Financial Markets
Vashi, Navi Mumbai
 


There are two types of investment options available to an investor. An investor can either invest in a scheme that gives an assured return like National Savings Certificate, PPF, RBI Relief Bond etc. or he can go for an investment option where returns are not assured like shares, mutual funds, unsecured debentures etc. While investing in the second type of investment option the biggest risk that an investor faces is wiping out of the capital itself as the returns are not guaranteed. In many instances investors have ended up loosing some amount of capital that they had invested or in some unfortunate cases the entire capital itself. Such losses are common in case of equity investments. One of the route available to investors to invest in equities indirectly is mutual fund. Though mutual funds invest in diversified portfolio, they also run the risk of negative returns resulting in wiping out of initial capital invested by an investor. To overcome this uncertainty in mutual fund investment, SEBI has recently allowed mutual funds to come out with a scheme known as Capital Protection scheme. As the name suggests, investments in such schemes comes with a guarantee, albeit implicit, that the investor's capital will be safeguarded. Hence, irrespective of the direction in which the market moves or even if the scheme underperforms, the protection of the investor's capital is guaranteed by the AMC (Asset Management Company).

How does Capital Protection Scheme work?

It is critical for an investor to understand how capital protection scheme works. At the outset an investor should know that a capital protection scheme is not an assured return scheme. In case of an assured return scheme both principal as well as returns on that are assured. However in case of a capital protection scheme only the capital is protected and not the returns. Second feature of a capital protection scheme is that it would be close ended by nature. This effectively means that an investor won't have an exit option in capital protection scheme. The close-ended structure will enable the fund manager to manage the portfolio with the benefit of a defined maturity i.e. no worries about redemptions and fresh inflows; for investors this is a good sign, but it also means blocking of funds. Investors should make sure that they invest only that portion of their capital, which they will not need in the near future. All the mutual funds which come out with capital protection scheme will have to get their portfolio rated a SEBI-registered credit rating agency. This is done with the aim of assessing the degree of certainty for achieving the objective of capital protection. Also as per SEBI's guidelines, the rating should be reviewed on a quarterly basis and the AMC should ensure that the debt component of the portfolio structure has the highest investment grade rating (AAA, P1+ for instance). The investor will draw comfort from the rating knowing that the portfolio quality is under a constant watch. However it is important to note that in a capital protection scheme, investment in equities is not prohibited. These funds can also invest, based on their investment mandate, a portion of their net assets in equities to generate capital appreciation.

Reliance Mutual Fund and Franklin Templeton have already filed the prospectus with SEBI for launch of capital protection schemes.The prospectus speaks volumes about the nature of the scheme.The prospectus of Reliance Mutual Fund states following about the investment objective,'The investment objective of the scheme is to provide protection of capital and its long-term growth with current income in line with the maturities of various target dates.'

Should You invest in  Capital Protection Scheme? The question that an investor needs to ask is should he invest in a capital protection scheme. It is for sure that this scheme is not meant for investors who are risk seeker by nature. It would suit the needs of risk averse and risk neutral investors. Capital Protection Scheme can serve as a good transition product for low risk investors who are primarily exposed to FDs and small saving schemes like Public Provident Fund (PPF) and National Saving Certificate (NSC). This class of investors who have shunned mutual funds so far because of their market-linked nature can migrate to a 'soft investment' like a Capital Protection Scheme.However it would be unfair to expect, extra-ordinary return from Capital Protection Schemes.Another aspect of CPS that needs to be looked at is tax saving part of it. In terms of tax efficiency, investors in the higher tax brackets could be better off investing in CPS as opposed to FDs. CPS being debt funds have their dividends taxed at 14.03%, while FDs are taxed at the marginal rate of tax.
 


Vivek Sharma
Faculty
Institute for Financial Markets
Vashi, Navi Mumbai
 

Source: E-mail September 26, 2006

     

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