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Do capital protection funds really protect your capital? - Outside View by PersonalFN
Do capital protection funds really protect your capital?

Recently, since a year back the mutual fund industry witnessed a new breed named "capital protection funds" mushrooming in the market which is already flooded with more than 4,000 mutual fund schemes. The launch of these capital protection funds was also quite strategic as the product head along with the marketing teams introduced such mutual fund schemes in a scenario where interest rates were on a rise, debt markets were active (after the slowdown of 2008 and early 2009) and investors confidence was once again back.

Most investors getting mis-led by the name of "capital protection", exuded confidence in such a mutual fund without even recognising what such schemes are and how they function. Mutual fund houses claimed that such a scheme would provide you investors’ dual benefit - capital protection if the equity markets do not perform well (through their dominant debt market exposure), and gains if equity markets turn buoyant. And many of you either getting swayed by these tall claims or being ignorant, failed to read the fine print imbibed in their investment objective that such schemes seek to provide and income by minimising risk of capital loss (by investing in debt market instruments) and not completely protect your capital (i.e. principal amount) while investing a diminutive portion in equity markets.

Remember, it is imperative that you take wise investment decisions at least by assessing how a financial product is structured, and also evaluate whether the investment objective set therein suit yours as well.

Capital protection funds are close-ended mutual fund schemes which typically invest 75% - 80% of their assets in debt and the rest in equity and equity related instruments. Hence, from an asset allocation point of view they appear the similar to Monthly Income Plans (MIPs). And doing so allows them to participate in equity market bull rallies, but at the same time during the downside of the equity markets it upsets their returns, thus not imbibing in it "capital protection" per se.

While constructing a portfolio for the scheme, such funds adhere to the asset allocation mentioned above, but also align their debt as well as equity portfolio in accordance to the tenure of the scheme – which varies from 1 year to 5 years. Hence for a capital protection fund having tenure of 1 year, you may find the debt portfolio being exposed to short-term maturity papers. While those having a tenure upto 5 years may expose themselves toward longer maturity papers, and for the equity component may invest across market cap segment (i.e. large caps, mid caps or small caps) depending upon economic factors, market conditions, market opportunities, political and regulatory environment.

How capital protection funds have fared?
Scheme Name 1-Yr (%) 2-Yr (%) 3-Yr (%) 5-Yr (%) Since Inception (%) Std. Dev (%) Sharpe Ratio Equity (%) Debt & cash (%)
Capital Protection Funds
FT India Cap Safety-5Yrs (G) 2.0 5.2 8.9 - 8.1 1.88 0.05 18.5 81.5
UTI CPO-1- 5 Yrs (G) 0.1 3.2 8.2 - 8.3 2.42 0.02 23.0 77.1
Birla SL CPO-5Yrs (G) 0.9 3.4 7.0 - 6.6 1.61 -0.02 0.0 100.0
Sundaram CPO 1- 5 Yrs (G) 0.7 2.7 5.4 - 6.2 2.00 -0.07 19.7 80.3
IDFC CPO-I (G) 0.9 3.3 - - 3.4 0.94 -0.30 13.9 86.1
Category Average* 0.9 3.6 7.4 - 6.5 1.8 -0.1 - -
Crisil MIP Blended Index 1.2 4.8 7.4 9.3 - 1.85 0.00 - -
Monthly Income Plans
Reliance MIP (G) 1.0 6.1 15.1 12.1 11.1 2.54 0.26 19.2 80.8
HDFC MIP-LTP (G) 1.6 7.6 13.1 12.4 11.9 2.82 0.17 23.0 77.0
Canara Robeco MIP (G) 2.6 6.5 11.4 12.7 7.5 2.39 0.15 15.7 84.3
Birla SL Monthly Income (G) 2.1 6.4 10.0 10.1 11.6 2.07 0.12 10.7 89.3
UTI MIS Adv (G) 1.7 6.0 9.7 10.3 10.0 2.12 0.10 24.2 75.8
Category Average* 1.8 6.5 11.9 11.5 10.4 2.39 0.16 - -
Crisil Balanced Fund Index -4.0 5.5 7.9 13.0 - 6.34 0.03 - -
(NAV data is as on June 13, 2011. Standard Deviation and Sharpe ratio is calculated over a 3-Yr period. Risk-free rate is assumed to be 6.37%)
*Note1: Category average has been calculated taking the “simple average”, of all the funds in the respective categories and not only the
set of funds above in each category.
Note 2: % of equity and debt holdings for all the funds are as on May 31, 2011
(Source: ACE MF, PersonalFN Research)

As far as the returns are concerned, so far most capital protection funds have delivered quite unappealing returns when assessed both on 3-Yr and 5-Yr time frame. In fact when assessed from an inflation adjusted returns point of view, they have eroded wealth for you investors as the inflation has eaten away the profits. Moreover, the risk which they have exposed their investors’ is quite low, and so are the risk-adjusted returns.
Portfolio Comparison
Scheme Name AAA / P1+ (%) AA+ / LAA+ & Below (%) Sovereign (%) Unrated (%) Deposits (%) Equity (%) MF units (%) Cash & Cash Equivalent (%) Avg. Maturity (in years) Top 10 Holdings (%)
FT India Cap Safety-5Yrs (G) 65.50 12.83 - - - 18.45 - 3.22 0.99 -
UTI CPO-1- 5 Yrs (G) 48.27 26.57 - - 0.02 22.95 - 2.19 0.69 12.7
Birla SL CPO-5Yrs (G) 67.20 10.89 - 16.95 - - - 4.96 1.22 -
Sundaram CPO 1- 5 Yrs (G) 11.95 - 56.89 - - 19.69 - 11.48 1.50 19.7
IDFC CPO-I (G) 80.94 - - - - 13.93 2.07 3.06 1.90 7.9
Portfolio as on May 31, 2011
(Source: ACE MF, PersonalFN Research)

Moreover, while most capital protection funds have held a dominant portion of the assets in good quality assets along with fair allocation towards equity assets, the rise in yields (due to the rise in interest rates, led by sticky inflation) of debt instruments across maturities have negatively impacted the debt portfolio. The equity portfolio has got distressed by the volatility witnessed by the equity markets.

However, MIPs on the other hand despite being exposed to the same risk (as mentioned above) for their debt and equity portfolio have not been impacted much on the return front - in fact have delivered luring returns. This is because their debt portfolio is not confined by a time frame (tenure) which allows them to shift between longer maturity papers and short maturity papers depending upon the prevailing interest rate scenario. Similarly for the equity portfolio the multi-cap strategy followed by them allows them to accentuate returns for their investors.

Taxation of capital protection funds:

It is noteworthy that since capital protection funds hold a dominant portion of its assets in debt instruments, the taxation is from that angle as well.

If such a scheme is held for period of more than 12 months, it would be treated as long-term capital asset and hence the long-term capital gains will be taxed at the rate of 10% without availing the indexation benefit or 20% by availing the indexation benefit (whichever is less). However, if you opt for the dividend option for your investments, the dividend received by you will be exempt, as the mutual fund house defrays a dividend distribution tax (DDT) of 13.519% (12.50% DDT + 5.00% Surcharge + 3.00% education cess).

Hence, the taxation of capital protection funds also is a discouraging factor while investing. Moreover, if the returns are as such unappealing the aforesaid tax angle makes it further more dismaying. It is noteworthy that even MIPs are enfolds in them the same tax implications as capital protection funds.

The verdict:

Thus it is imperative that you don’t get swayed by fancy names which often are misleading, and which add to the anarchy to the market which is already flooded with more than 4,000 mutual fund schemes. It is vital that you recognise how the scheme works and whether it suits your investment objective along with your risk appetite. Even while seeking services of your mutual fund advisor you need to ensure that he is often independent and unbiased advice, keeping his vested interest (of earning commissions) at bay.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.


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