Market uncertainties make fund houses line up capital protection funds, we explore why they have suddenly found favour
05-Jan-2011 •Research Desk
The launch of two new capital protection funds from JP Morgan and Sundaram Mutual and four more AMCs waiting for necessary Sebi clearance to launch similar funds has re-kindled the interest in this category of funds. These funds first made an appearance in 2006, when interest rates started to move up and were targeted at investors with low risk appetite, looking for a substitute better than bank fixed deposits.
There are five funds that have been in existence in this category that have had a mixed performance (See table: Performance Returns). Compared to bank fixed deposit returns, these funds have done well over 1- and 2-year return performance. However, the real test of these funds is when they are held till maturity of 3- or 5-years. They do not seem to be as attractive as fixed deposits, but are actually tax efficient in comparison to fixed deposits. The gains that one makes on these funds, for those in the highest tax bracket, is taxed at 10.3 per cent tax without indexation or 20.6 per cent with indexation whichever is lower. In comparison bank fixed deposits interest attracts 30.9 per cent tax, which most often does not match inflation. In real terms, when adjusted to inflation, bank fixed deposit eats into the capital.
Investors looking to invest in these funds should do so with due diligence (Read: Investor Checklist). The timing of these funds is a lot to do with the change in interest rates. Says Ritesh Jain, head of fixed income, Canara Robeco Mutual Fund; “As the shot-term interest rates are high, the funds launched now will be able to have a higher equity allocation while ensuring the principal amount remain safe.” AMCs plan to make use of this opportunity by buying debt papers at cheap rates, on back of rising bank rates and hold them till maturity thus earning higher return. This assures them higher interest income from debt allocation, while they can deploy more funds into equities and achieve the dual benefit of capital protection and higher than bank fixed deposit returns.
Here are few points to consider before investing in capital protection funds.
• Target: Risk averse investors and those who are predominantly into fixed deposits and fixed return investments.
• Portfolio: This is a conservative hybrid fund, with 75-80 per cent debt allocation to check on capital loss. The remaining equity exposure aims for capital appreciation.
• Return: These funds cannot indicate returns, one can estimate returns based on the performance of existing similar funds.
• Taxation: Investors in the highest tax bracket attract 10.3 per cent tax without indexation or 20.6 per cent with indexation, whichever is lower compared to 30.9 per cent tax that interest income on fixed deposits attract.
Caveat Emptor: Don’t be misled by the name. These are capital-protection-oriented funds and do not guarantee capital protection. These are closed-end, with a 3 to 5 year lock-in, are illiquid compared to fixed deposits, which offer overdraft and loan facility against deposits. And, though the schemes are listed on the stock exchange, they still remain illiquid owing to lack in trade volume.