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Are capital protection funds better than FDs?

Equity is considered the best asset class to go with in inflationary times, as they have given positive inflation-adjusted returns over a longer period

INVESTORS have witnessed uncertainty and volatility in financial markets over the past two years. The global financial crisis induced a sense of risk aversion among most investors. While many have shifted to safe haven assets like gold and silver, others have relied on bank deposits to protect and grow their hard-earned money.

With interest rates showing an upward trend, fixed deposits now offer a much envied blend of safety and competitive returns. But then, there is a chink in the armour, inflation! With food inflation ruling in double digits, although bank fixed deposits are close to offering interest rates in double digits, they may still fail to beat inflation and end up generating negative returns on your deposits.

Equity is considered the best asset class to go with in inflationary times, as they have given positive inflation-adjusted returns over a longer period. While there is no shying away from the fact that volatility persists in the equities market, the right style and approach of investing is crucial in order to achieve long-term gains. This is where the need arises for a product that can offer both the safety of fixed income and capital appreciation similar to equities.
Capital protection-oriented funds are conceived with this objective of providing capital protection and ensuring growth in a single product.

These are close-ended debt-oriented mutual fund schemes that invest in a mix of fixed income instruments and equities. The tenure of such schemes ranges from two to five years.

These funds achieve the purpose of capital protection by way of fixed income allocation, as they follow a passive style of investment.
They invest in the highest rated debt instruments, which mature on or before the maturity of the scheme and investments are made in such a fashion that the final maturity value of the fixed income investments is equal to or greater than the principal of the scheme.

The share of fixed income out of the total portfolio is decided on the basis of the prevalent interest rate. The rest is invested in equities. This performs the role of alpha generator in the portfolio.

A simple illustration can explain the concept more clearly. Suppose an investor buys units worth Rs 10,000. Assuming the fund generates nine per cent yield on the fixed income portion, it will require Rs 7,700 to earn Rs 10,000 in three years and thus protect the investor's capital.

This leaves out Rs 2,300, which is to be invested in the equities market for potential upside participation. Assuming that the investment in equities appreciates at a rate of 25 per cent, the total returns on the principal investment will be approximately 13 per cent. On the other hand, if the market corrects 10 per cent, still the total return on the principal investment will be approximately 5.25 per cent.

Are these funds better than bank FDs?

Capital protection-oriented funds provide
a credible portfolio solution in an inflationary environment by combining the concept of `capital protection' with that of `capital growth' within a single fund. While the fixed income portion protects the capital, the equity portion gains from the India growth story. A longer investment horizon (say two to five years) compliments the equity returns in the portfolio.

Historical data (between 1991 and 2010) shows equities have delivered positive return in 80 per cent times over a three-year horizon while in a one-year time horizon, investors have received positive returns in 65 per cent of times.

Also, the recent correction in the equities market can be looked at as an excellent opportunity to build this kind of a portfolio. In terms of taxation too, capital protection-oriented funds provide a tax-efficient solution. If held more than a year under the growth option, an investor will pay 10 per cent tax without indexation and 20 per cent with indexation; whereas in case of fixed deposits, the returns are taxed according to the marginal tax bracket (30 per cent in case of the highest tax bracket). However, it is best to consult a tax advisor before taking a call on this aspect.

In our view, capital protection-oriented funds are appropriate for investors seeking to gain from equity participation without any risk of erosion in the capital invested.

 

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