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What are Capital Protection Funds & How to Invest?
Capital Protection Funds are mutual funds whose main purpose is to provide a safety net for the money invested at the time of purchase. This ensures that the capital can also provide nominal returns during a particular investment horizon.
This article will illustrate the aim of Capital Protection Funds, how they work, and the processes of investing them to help individuals make better decisions about these kinds of investments.
Table of Contents
What is a Capital Protection Fund?
A capital protection fund is a closed-end hybrid fund. Its primary objective is to safeguard investors' capital during market downturns while simultaneously offering them scope for capital appreciation by participating in stock market upturns.
This fund invests in fixed-income instruments such as bonds, certificates of deposits (CDs), treasury bills, and equity instruments. Besides this, a small portion of the portfolio has investments towards equity to take advantage of the growth advantages and provide capital appreciation.
In other words, most of the fund corpus is invested in fixed-income securities to earn stable returns on the invested capital.
How Does a Capital Protection Fund Work with Examples?
Capital protection funds usually allocate at least 80% of the fund corpus to AAA-rated bonds, with the remaining capital invested in equity securities.
The amount allocated to debt securities ensures that an investor's principal investment is recovered at maturity. Accordingly, these funds invest in debt securities with the highest rating. Furthermore, since these schemes hold the debt instruments till the end of the maturity period, interest rate risk is mitigated.
On the other hand, fund managers of these schemes invest the rest of the fund corpus in equity and equity-related instruments to achieve capital appreciation.
Consider the following example to understand the workings of a capital protection fund:
Benefits of Capital Protection Mutual Funds
Here are the features and advantages of investing in a capital protection fund:
1. Balanced Portfolio
These funds allocate the pooled funds primarily to fixed-income securities like zero-coupon bonds and equity investments, creating balance and stability for investors.
2. Capital Protection
Capital protection funds guarantee the return of the investor's principal amount at maturity, providing peace of mind that the original investment will be safe.
3. Closed-Ended Scheme
These funds typically operate as closed-ended schemes, meaning they are not open for redemption or fresh investments until maturity, providing stability and predictable returns.
4. Lock-In Period
Capital protection funds often have a lock-in period during which investors cannot redeem their investments. This ensures that the funds remain intact for the investment.
5. Taxation Policy
Returns from capital protection funds face capital gains tax. Long-term capital gains (LTCG) are taxed at 12.5%, while short-term capital gains (STCG) are taxed at 15%.
Are Returns on Capital Protection Funds Guaranteed?
No, returns on Capital Protection Funds are not guaranteed as these investments are not entirely risk-free.
SEBI, or the Securities and Exchange Board of India, has assigned credit rating agencies to provide ratings to the fund structure of capital protection funds. It has also assigned them to evaluate a scheme's reliability to deliver assured returns. All these have been done to ensure the protection of the invested capital.
As per SEBI, AMCs cannot market this fund as "oriented towards protection of capital." Furthermore, the regulator mandates that asset management companies declare "no guaranteed capital returns."
Who Should Invest in a Capital Protection Fund?
Capital protection-oriented schemes are suitable for the following individuals:
- Investors seeking stable returns
- Individuals who have a low-risk appetite
- Investors who wish to earn higher returns than savings and fixed deposits
- Individuals who prefer capital protection to capital appreciation
Unlike open-ended debt funds, capital protection funds come with a lock-in period. Individuals must wait to exit the scheme before the end of the maturity period.
To sum up, investors who fear stock market volatility but are unwilling to risk losing out on opportunities to generate profits can consider investing in close-ended hybrid schemes like capital protection funds.
Novice or first-time investors seeking equity exposure can also consider investing in these funds.
How to Invest in Capital Protection Funds?
Investing in capital protection funds will depend on risk appetite, investment horizon, and liquidity needs. We have mentioned the following steps to invest in such funds.
Step 1
Go to the AMC website and open the account.
Step 2
Complete the KYC process.
Step 3
Choose the fund scheme you want to invest in.
Step 4
Select the plan (Direct Or Regular) that you want to go for.
Step 5
Select the investment mode(SIP or Lumpsum) and complete the payments by providing the necessary details.
Step 6
Finally, monitor the fund performance regularly for better returns and profits.
Note: Please read all the scheme-related documents to understand the returns, risks, and expense ratios involved, and take note of asset allocation before investing.
Taxation on Capital Protection Funds
Capital protection mutual funds invest over 65% of the fund corpus in debt instruments. Accordingly, such schemes are taxed as debt funds. If investors opt out of a scheme before 3 years, the gains earned are known as short-term capital gains (STCG). These returns are taxed at the investor's income tax slab rate.
For Example: Let's assume you invest ₹5,00,000 in a Capital Protection Fund, where 60% (₹3,00,000) is allocated to debt instruments, and 40% (₹2,00,000) is invested in equities.
Scenario 1: Debt Portion - Long-Term Investment
- Investment: ₹3,00,000 in debt instruments for 4 years.
- Capital Gain (after 4 years): ₹50,000
- Tax Calculation: Since it is a long-term capital gain, the tax will be at 12.5% with indexation (assume indexation benefits reduce the taxable gain to ₹45,000 after inflation adjustment).
- Tax = ₹45,000 * 12.5% = ₹5625
Scenario 2: Equity Portion - Short-Term Investment
- Investment: ₹2,00,000 in equities for 6 months.
- Capital Gain (after 6 months): ₹30,000
- Tax Calculation: Since it is a short-term capital gain (within 1 year), the tax will be at 20%.
- Tax = ₹30,000 * 20% = ₹6000
Total Tax Liability:
Debt portion tax = ₹5625
Equity portion tax = ₹6000
Total Tax = ₹5625 + ₹6000 = ₹11625
Summary of Taxation:
- Debt portion (long-term): Taxed at 12.5% with indexation, resulting in ₹5625 tax on ₹45,000 gain.
- Equity portion (short-term): Taxed at 20%, resulting in ₹6000 tax on ₹30,000 gain.
Are Capital Protection Funds Better than Fixed Deposits(FDs)?
While comparing Capital Protection Funds (CPFs) with Fixed Deposits (FDs), several key factors make CPFs attractive to confident investors. A few such factors are listed below:
1. Higher Return Potential
Capital Protection Funds (CPFs) can offer higher returns than fixed deposits (FDs). While FDs provide fixed returns, usually about 5-7% per annum, CPFs invest a part in equities.
2. Inflation Hedge
CPFs have the potential to reduce the effects of inflation. FDs offer long-term fixed returns; recently, they have remained less effective than inflation and eroded real purchasing power. The equity of CPFs grows faster than inflation.
3. Tax Effectiveness
CPFs, in some cases, become more tax effective. While FD interest is subject to tax under your slab rate, the profits from equity in CPFs suffer lower capital gains tax (10% after one year), which is beneficial.
4. Diversification
CPFs facilitate diversification by investing in both debt and equity instruments. It generally reduces risk compared to the FDs because they are solely fixed-income instruments. Such a hybrid nature helps CPFs balance the capital.
5. Long-term Growth
CPFs are best suited for medium to long-term investment. The equity part of it may yield higher dividends after many years. On the contrary, FDs are the best short-term investments and offer little growth in the long run.
6. Liquidity
CPFs are more easily liquidated than FDs. While FDs lock you into a sum for a set term, you can redeem units from a CPF after a lock-in period (usually 3 years), which is more flexible in an emergency withdrawal.
Things to Consider Before Investing in Capital Protection Funds
Investors might want to consider these aspects before investing in capital protection-oriented mutual fund schemes.
1. Investment Objective
Individuals' financial goals are not the same. While some may seek maximum capital appreciation, others might want to earn stable returns. Hence, before investing, investors must identify their financial goals and ensure that they are in line with the fund's investment objective.
2. Expense Ratio
The expense ratio is a charge that fund houses levy on investors every year. Asset management companies impose this fee to cover the costs incurred for running the fund. Such costs include various expenses, including distribution fees, administrative expenses, fees charged by fund managers, etc.
This annual fee directly impacts the returns of investors. Hence, they must compare the expense ratio of different capital protection-oriented schemes before opting for a scheme.
3. Investment Horizon
Investment time horizon refers to the duration an investor is willing to stay invested in a scheme. Similar to financial goals, the period for which investors would like to hold the units in a scheme will differ from one individual to another. Individuals must ensure that the investment time horizon is by their financial goals.
4. Risk Involved
Capital protection-oriented schemes are low-risk investments as the funds primarily allocate the fund corpus to top-rated debt instruments. Investors must ensure to assess their risk profile before allocating their savings. Individuals with a high risk-bearing ability may consider opting for funds with higher equity exposure.
5. Past Returns
By checking the past returns of the fund, investors can get to know whether the fund has been successful in achieving the goals that it was set up to achieve. In other words, the past performance of a scheme represents a fund's consistency. That said, keep in mind that the fund's past returns do not indicate how it will perform in the future.
6. Asset Ratings
Asset ratings are the creditworthiness of the debt securities or assets in the capital protection fund. These ratings, issued by agencies such as CRISIL, ICRA, or Moody's, indicate the risk of default associated with the underlying assets. A higher rating indicates a lower risk; this is important for ensuring the fund meets its capital protection objectives.
7. Asset Allocation
Asset allocation is how the funds' investments are distributed within different asset classes in debt instruments, equities, or other securities. In the case of capital protection funds, an overbearing percentage is channeled into low-risk debt instruments like bonds. Still, a smaller percentage will be channeled toward equities with growth potential.
Disclaimer: The information provided on this website is for general informational purposes only and should not be construed as financial, investment, or legal advice. While we strive to provide accurate and up-to-date content, we do not guarantee the completeness, reliability, or suitability of the information for your specific needs.
We do not promote or endorse any financial product or service mentioned in these articles. Readers are advised to conduct their own research, consult with financial experts, and make informed decisions based on their unique financial circumstances. Any reliance you place on the information provided here is strictly at your own risk.
FAQs about Capital Protection Funds
What are the fees associated with the Capital Protection Fund?
What is a capital protection fund?
Why are capital protection funds better than Fixed Deposits?
What are the considerations before investing in capital protection funds?
What are the benefits of capital protection funds?
The benefits of capital protection funds are:
- provide security of the principal amount
- modest returns
- low risk
- Diversification and
- Well-balanced portfolio.
They allow investors to generate higher returns than traditional fixed-income products with minimal downside risk.
What are the risks involved in capital protection funds?
Are returns guaranteed on capital protection funds?
Who should consider investing in capital protection funds?
Can investors access/redeem their capital protection funds before the maturity date?
What is the typical investment horizon for capital protection funds?
Is there any lock-in period for capital protection funds?
Which debt instruments are considered the safest in terms of credit ratings?
Other Important Articles about Mutual Funds
Disclaimer
- This is an informative article provided on 'as is' basis for awareness purpose only and not intended as a professional advice. The content of the article is derived from various open sources across the Internet. Digit Life Insurance is not promoting or recommending any aspect in the article or its correctness. Please verify the information and your requirement before taking any decisions.
- All the figures reflected in the article are for illustrative purposes. The premium for Coverage that one buys depends on various factors including customer requirements, eligibility, age, demography, insurance provider, product, coverage amount, term and other factors
- Tax Benefits, if applicable depend on the Tax Regime opted by the individual and the applicable tax provision. Please consult your Tax consultant before making any decision.
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