Capital Protection Funds

Capital Protection Funds safeguard investors’ capital in the event of market downturns.
EXPLORE FUNDS
Capital Protection Funds
EXPLORE FUNDS
4 mins
20-May-2024

Capital protection funds are specialised close-ended hybrid investment options designed to offer investors the potential for equity-like returns while also providing some security. These funds aim to safeguard the capital of investors during market downturns while also allowing for capital appreciation during market upswings. The primary goal of capital protection mutual funds is to protect investors' capital in times of market volatility. Simultaneously, they aim to capitalise on the equity market's potential for growth. This article covers what is a capital protection mutual fund, how capital protection funds operate, what are the uses of capital protection funds, and much more.

What is a capital protection mutual fund?

A type of structured financial instrument that ensures a specified minimum value upon maturity alongside potential growth opportunities. Products featuring capital protection offer the chance for profits while safeguarding a portion or the entirety of the initial investment.

Capital protection funds have served as a shield against economic shocks for centuries. They operate by acquiring assets expected to depreciate in value and retaining them until their prices rebound. This strategy not only safeguards investors' funds but also contributes to economic stability during periods of uncertainty and downturns.

Governments establish capital protection funds to shield investors from unforeseen financial losses. By selling shares to the public and imposing investment limits, the government manages risk exposure. If share prices fall below a predetermined threshold, the government may raise investment limits or repurchase shares. These funds typically offer protection to investors during stock market crashes.

Managed by the government, capital protection funds aim to protect national assets during economic downturns. Originating in response to the 2008 global financial crisis, these funds are essential for maintaining economic stability at a national level.

Within the financial system, capital protection funds serve a critical role. They act as a cushion against broader economic downturns, helping to preserve asset values and providing a safety net for individuals facing unemployment. By shielding investors from unexpected declines in asset values, these funds contribute to economic stabilisation and investor confidence.

How capital protection funds operate?

These funds are typically close-ended hybrid schemes, with approximately 80% of the portfolio invested in fixed-income instruments like bonds, certificates of deposit, and treasury bills. The remaining portion is allocated to equity and equity-related instruments, such as convertible debentures, preference shares, warrants, and derivatives, following SEBI guidelines. Capital protection funds aim to strike a balance between protecting the invested capital and generating returns by diversifying the portfolio with both low-risk and higher-risk assets.

What are the uses of capital protection funds in India?

Particulars

Details

Supporting financial institutions

Capital protection funds provide financial guarantees to banks and other financial institutions, ensuring their solvency and reducing the risks they pose to the economy. They are also referred to as financial stability funds or funds for bank recapitalisation.

Hybrid funds for capital protection

These closed-end hybrid funds focus on safeguarding investors' capital during market downturns while enabling participation in stock market upswings to benefit from capital appreciation.

Guaranteed return bonds

Bonds offering guaranteed returns provide exposure to the stock market with the promise of higher returns alongside a safety net. They ensure fixed capital payments at specified times or upon death.

Diverse investment options

Capital protection funds offer various investment avenues such as certificates of deposit, fixed annuities, fixed indexed annuities, high-yield savings accounts, money market accounts, treasury bonds, treasury inflation-protected securities, and whole life insurance, among others.

Eligibility and business benefits

To comprehend the functioning of the capital guarantee fund, understanding eligibility criteria and benefits to businesses is essential. Established in 1933, this fund has supported companies by providing a financial safety net in case of loan default. By preventing unexpected business interruptions, it enables normal business operations while issues are resolved.

 

Who should invest in capital protection funds?

Capital protection funds are best suited for investors with certain preferences and financial goals. You should consider investing in capital protection funds if you are:

  • Risk-averse investors: If you are risk-averse and want to protect your capital from market downturns, capital protection funds are an ideal choice. These funds provide a level of security akin to fixed deposits while also offering the potential for equity-like returns.
  • Avoiding interest rate volatility: For those who wish to avoid the interest rate fluctuations associated with traditional fixed-income investments, capital protection funds can be a suitable alternative. The debt component of these funds provides stability.
  • Matching investment horizon: When your investment horizon aligns with the tenure of a capital protection fund (typically 3-5 years), it can be a strategic choice. These funds are best for those who can commit their funds for the specified period.

Also read - What are mutual funds?

Allocation of capital protection funds

Capital protection funds are a blend of fixed-income securities, such as zero-coupon debt, and equity investments. This combination aims to provides investors with principal protection through the fixed-income segment of the portfolio while allowing for additional gains from the equity portion. Portfolio managers structure these funds to ensure capital protection.

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Benefits of capital protection funds

  • Capital protection: Investing in capital protection funds is ideal for risk-averse investors who want to benefit from equity investments while safeguarding their principal amount. These funds strike a balance by allocating 80% to highly rated debt instruments and the remainder to equity. When equity markets perform well over the fund's tenure (usually 3-5 years), investors can witness substantial growth. In adverse scenarios, their capital remains protected.
  • Balanced portfolio: These funds provide a balanced investment portfolio that combines fixed-income securities, typically zero-coupon debt, and equity investments. This balance allows investors to enjoy the security of fixed-income instruments while still benefiting from potential equity market gains.

Also read - Different types of mutual funds

When to consider capital protection funds

  • During market volatility with medium to low inflation levels.
  • If you are averse to interest rate volatility.
  • When you want to participate in equities while minimising the associated risks.
  • When your investment horizon aligns with the fund's tenure.

Capital protection funds offer a suitable option for individuals with specific financial goals who wish to secure a portion of their initial investments without forgoing the benefits of equity investments. It is important to note that the Scheme is “oriented towards protection of capital” and not “with guaranteed returns”. Further, the orientation towards protection of the capital originates from the portfolio structure of the scheme and not from any bank guarantee, insurance cover etc.

Are capital protection funds better than fixed deposits?

When prioritising capital safety, capital protection funds surpass Fixed Deposits (FDs). These funds typically yield superior post-tax returns compared to other fixed-income options such as fixed maturity plans.

How do I choose a capital protection fund?

When selecting an investment scheme, it is crucial to align your choice with your investment objectives, risk tolerance, and liquidity needs. Prior to opting for a capital protection fund, it's advisable to consider the following factors.

Firstly, thoroughly examine the investment objective of the fund to ensure it aligns with your own investment goals and preferences.

Secondly, check the rating assigned by Credit Rating Information Services of India Limited (CRISIL) to the capital protection-oriented schemes. This rating indicates the likelihood of the portfolio value dropping below the initially contracted principal value, or the assurance of investors receiving their entire investment back. It's essential to verify the CRISIL rating or the specific scheme's rating.

Thirdly, evaluate whether the tenure of the scheme corresponds with your investment horizon, ensuring it suits your financial goals and timeframe.

Lastly, pay close attention to the asset allocation strategy outlined in the fund's offer document. Understanding the risks undertaken by the fund manager to potentially boost returns is paramount. Carefully assessing these risks can help you make an informed decision about whether the fund aligns with your risk tolerance and investment objectives.

Conclusion

In conclusion, capital protection funds emerge as a compelling investment option for those seeking to safeguard their capital while aiming for potential returns. These funds offer a balanced approach by combining elements of fixed-income securities with equity investments, providing investors with a level of capital protection alongside growth opportunities. With their focus on preserving the principal amount, capital protection funds mitigate downside risks and offer a degree of assurance in uncertain market conditions.

However, it is crucial for investors to conduct thorough research, considering factors such as the fund's investment objective, credit rating, tenure, and asset allocation strategy. By carefully assessing these aspects and aligning them with their investment goals and risk tolerance, investors can make informed decisions regarding capital protection funds to optimise their investment portfolios.

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