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Capital safety, modest returns

Structured products such as capital protection funds allow investors to gain an exposure to equities without the risk of a downside.

If you had invested in equities in 2008, chances are you are still reeling from the losses. Besides, your real rate of return on any debt investment at that time would also be negative considering the double-digit inflation.

Given the current uncertainty in the markets, investment options seem limited, especially when you want to protect your capital while generating moderate returns.

Though higher returns usually come with higher risk, there are products that guarantee safety of capital with the possibility of an upside. Structured products invest in various financial instruments in accordance with your risk profile and objectives, and offer protection of principal if held till maturity.

Protection Strategy

Globally, there is a variety of structures that have the returns linked to an underlying portfolio, which could be stocks, bonds, futures and options of stocks, interest rates, etc. In order to bring these products to retail investors, mutual funds came up with capital protection products in 2006-7. How do these work? The capital guarantee is offered through a debt portfolio, which grows to the initial investment value at the time of maturity.

Capital protection funds should be considered when you need to reduce your participation in the stock market
"Typically, an allocation of 80% is made to debt, which can earn you a return of 7-8.5% from corporate bonds at present," says Sunil Subramaniam, executive director (sales and marketing), Sundaram Mutual.

"In effect, Rs 80,000 invested in a corporate bond for three years at 8% will have a maturity value of Rs 1,00,777. This covers your initial capital of Rs 1 lakh. The rest of the portfolio, 20%, is invested in an actively managed diversified basket of growth stocks, giving you exposure to the equity markets," he adds.

The percentage in the equity portfolio changes from the initial allocation according to the returns generated. In a bullish market, the asset allocation of, say, Birla Sun Life Capital Protection Oriented Fund, is similar to that of a balanced portfolio.

In a bearish market, the asset allocation is like that of a monthly income plan portfolio. These products are launched regularly and are available for tenures of three-five years. No exit option is available for these funds.

Wealth Management

The Indian market, too, has come of age and offers tailor-made products to its investors. Some of the most common among these are equitylinked or market-linked debentures, provided by many non-banking financial companies (NBFCs) and wealth management firms. Earlier, these were typically offered to high net worth individuals and came in larger ticket sizes.

Now, many companies are providing these products even to small portfolios worth Rs 5 lakh. These products are usually issued in the form of non-convertible debentures, which carry a fixed coupon rate and provide returns linked to the underlying stock or index. You may end up paying 4-5% for these structures, while the capital protection funds come with a lesser charge of around 2% per year.

Measuring Performance

The market-linked debentures are similar to capital protection funds, says Anil Rego, CEO, Right Horizons, except that these products could be structured differently according to the tenure, participation ratios and trigger limits.

After putting in a pre-determined percentage of the investment in fixed income securities, the issuer invests the rest in call options, which provide exposure to equities. These debentures are linked to an equity index. The difference between the index level at the start and maturity of the debenture is multiplied by the participation ratio, which is the ratio at which the debenture participates in appreciation of the underlying index.

If the participation ratio is 90% and the equity index gives a return of 50% during the period, the return of the product will be 45%. Equity-linked debentures have a knockout level. If the index appreciates more than the percentage mentioned in the debenture, a fixed coupon rate is paid. One should be aware of this before investing.

Risk-averse Strategy
Capital protection funds, launched in 2006-7, have outperformed the income funds in the past one year.


Tax-efficient Alternative

Capital protection funds have beaten the income funds over the past six months and one year. In fact, they are better than fixed deposits, which offer you 7.5% per annum on a one-year deposit. This works out to a post-tax return of 5% in the 30% tax bracket.

The returns from capital protection funds are subject to long-term capital gains tax of 10%, making them more tax-efficient. More such products are launched when the downside risk in the market increases. Also, when the valuations become increasingly expensive, capital protection funds tend to become more popular, says Rego.

Risk Factors

Structured products are guaranteed by either the issuer or a guarantor. If the underlying instruments are government bonds, your money is safe, but if these are, say, a bond issued by a real estate company, then the guarantee is as good as the firm's credit.

This risk is somewhat lower with fund houses as there are more stringent regulations in place to safeguard investors' interests. All asset management companies that offer capital protection schemes have to get their portfolios rated by a credit rating agency which is registered with the Securities and Exchange Board of India.

Instead of bank fixed deposits, you should consider these funds as they offer capital protection with an exposure to equities and are more tax-efficient. "A capital protection scheme can serve as a good transition product for low-risk investors who want to get a flavour of equity," says Subramaniam.

Alternatively, you can create your own capital protection portfolio by investing 80% in debt funds and the balance in the stock market. It will lower your cost, but you will have to monitor your equity component to lock in to your desired rate of return.