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How Funds Spell Out Guarantee

Recently, SEBI came out with the regulations under which capital guarantee funds can be launched. The regulations carefully tip-toe around the word 'guarantee' without quite stepping into it

For many months, the word in the mutual fund industry has been that capital-guarantee funds are on their away. These are supposed to be funds where there is a guarantee that the investors' capital will not be eroded. No matter how bad things get, at least the initially invested amount will always be protected. Many in the mutual fund business feel that some investors see funds as unsafe and therefore a product that is planned around capital-safety would be acceptable to more investors.

A few days ago, SEBI came out with the regulations under which such funds can be launched and I suppose it's now only a matter of time before we start seeing actual schemes. SEBI's regulations on the matter are an interesting exercise. The regulations carefully tip-toe around the word 'guarantee' without quite stepping into it.

The regulations pave the way for the launch of what it names 'Capital Protection Oriented Schemes'. It says that these will be schemes that will 'endeavour' to protect the capital invested in them. The regulations also state that the funds will be rated by a credit rating agency 'from the viewpoint of the ability of its portfolio structure to attain protection of the capital invested therein'.

Translated from Legalese to English, what this means is that we will have funds that will try hard not to lose your money and which will be certified by a rating agency as having tried hard enough. Do note that we are only talking about an effort to protect capital, no one has said anything about the effort actually having to succeed.

Will this work? Here's what I predict will happen. When a fund salesman comes to you to sell a 'Capital Protection Oriented Scheme', he will orally refer to it as a 'guaranteed' scheme. When you ask him why the paperwork doesn't say it's guaranteed, he will probably give a philosophical speech about the real meaning of words like guarantee and warranty and how things used to be guaranteed in the good old days but are merely warrantied now. He will then tell you that it's the government that prevents it from being called guaranteed (which is true) but in reality it's just as good as guaranteed (which will not be true). Many of us will buy into these funds because we all know that the government prevents many good things.

Will there actually be a chance of losing money in funds like this? My hunch is that most such funds won't actually lose money but they won't earn much either. All in all, the long-term risk-free returns that one can earn in our economy will stay limited to perhaps three or four per cent above what you could earn by putting a fixed deposit in a bank. Of course, there's nothing wrong with that-three per cent more than an FD without risk is a pretty good deal.

However, if you are somehow led to believe that these will be funds that will rocket up along with the Sensex during bull runs and then miraculously not fall when the markets crash, then you are in for a surprise. In real life, these funds will rise gently when the market shoots up and then when the markets crash, they'll go down less than they went up earlier.

If you put your money in a post office deposit and then keep investing the interest in an equity fund, you will probably end up with the same capital protection and returns as this type of fund. Come to think of it, that's conceptually pretty similar to the kind of strategy that fund managers of such funds will follow anyway.