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Investing in Capital Protection Oriented Schemes
Capital protection are two words that are music to the ears of investors. However, it is important to know that Capital Protection Oriented Schemes (CPOS) are oriented towards capital protection and do not offer guaranteed returns. The “orientation” towards capital protection happens from the way their portfolios are structured and not from any insurance cover or bank guarantee. Here’s what you need to know when investing in capital protection oriented schemes of mutual funds.
Understanding Capital Protection Oriented Schemes
CPOS are essentially close-ended hybrid schemes. The majority of the corpus of such schemes (typically about 80%) is invested in debt and money market instruments while the remaining is invested in equity and equity related instruments. CPOS have tenures that range from 3-5 years.
As per the mandate of the capital market regulator, Securities and Exchange Board of India (SEBI), CPOS must ensure that the debt component of the fund grows to the initial amount invested during the tenure of the fund (thereby ensuring protection of capital). Besides, they must mandatorily be rated by a credit rating agency and must invest in instruments that have the highest rating.
How do CPOS’ work?
In a CPOS, allocation of the corpus to debt is done in a manner such that at the time of maturity the debt investment in the fund grows to the original investment in the portfolio. The equity component adds to the returns of the CPOS. There are two ways in which CPOS can participate in equity markets. A scheme may use the “plain vanilla” way of market participation wherein the scheme invests in equity and equity related instruments. On the other hand, it may take advantage of “leveraged market participation” by purchasing call options.
By using leverage, a CPOS can increase the equity participation in the market without reducing the debt component. For example, if a CPOS with a tenure of three years invests in a three year Nifty call option, and the price of call option is 20% of its value, the participation in the equity market would be 100/20 or 5 times. Therefore by smart use, even after investing 80% of its corpus in debt, a CPOS can have 100% (20x5) participation in the equity market.
However, what the investor needs to be mindful of is that, in such CPOS’ that choose leveraged market participation, the fund manager essentially takes a call that at the end of the Nifty option tenure the market will rise significantly. Therefore if the market does not move up as expected, the fund manager may choose not to exercise his option. Therefore the premium paid for buying the Nifty options will not be recovered if the market tanks or even if it stays flat. On the other hand, if an investor were to choose a plain vanilla fund the value of his portfolio would remain at the same level as it was three years ago, during the inception of the fund.
Let us examine the following examples to understand how CPOS operate:
Three year CPOS Direct Equity strategy
Corpus (₹) 100  
Allocation towards debt instruments (₹) 83  
Value of debt at maturity (A) 100  
Allocation towards direct equity 17  
CAGR (%) on equity allocation 20  
Value of equity at the time of the maturity of the scheme (₹) (B) 22.63  
Value of the CPOS upon maturity 122.63  
Therefore, in direct equity investing we can see the value of debt grew from ₹83 to ₹100 and with a CAGR of 20% ₹17 grew to ₹22.63 over the tenure of the fund. Therefore the value of the fund on maturity was ₹122.63.
Now let’s consider two scenarios in the equity option strategy over a period of three years:
  Scenario 1   Scenario 2  
Corpus (₹) 100   100  
Allocation towards debt instruments (₹) 83   83  
Value of debt at maturity (A) 100   100  
Premium option paid (to obtain 70% notional exposure) 17   17  
Annualised Nifty returns -10   10  
Value of equity at the time of the maturity of the scheme (₹) (B) (70% of ₹100 with CAGR of 10%)(When the returns on the Nifty are negative, the option contract does not generate returns. When the Nifty turns positive, 70% of the returns are generated and gained through the options contract.) -   23.17  
Value of the CPOS upon maturity (A+B) 100   123.17  
In the first scenario we see that the overall Nifty returns are negative, therefore the index options do not generate any income on the equity derivative investment. When the Nifty returns turn positive, the options contract generates a gain, thereby increasing the total value of the investment.
Benefits of investing in CPOS
For those investors, who are spooked by the volatility of stock markets and yet do not want to lose out on the opportunity of making gains, investing in close-ended hybrid schemes such as CPOS can be beneficial. CPOS allow you to enjoy the benefits of investing in equities without risking your principal amount. It is the best of both worlds as 80% of the fund allocation is towards debt instruments that is highest rated paper and the remaining is put in equities which is the cherry on the icing. If the equity markets are on a rise in three to five years you could see your investments grow well. On the other hand if the markets tank and the equity performance is dismal, your capital is still protected.
When should you choose a CPOS?
You should choose a CPOS in any of the following scenarios:
When markets are volatile and inflation level is medium to low.
When your investment horizon matches the CPOS tenure.
When you do not have the risk appetite for interest rate volatility risk.
When you want to participate in equities but do not want the associated risks.
When you seek tax efficient returns as compared to your fixed income deposits (Indexation benefits are available on CPOS over the long-term. You will be charged according to your income tax slab if you exit before maturity through stock market). Units of CPOS are listed for trading on the BSE and NSE, though the market may not be very liquid.
Conclusion
CPOS can be beneficial for people who have defined financial goals and want to lock a certain portion of their corpus for a period of three to five years to meet them. In the interim, if you do not want to lose out on the equity advantage, CPOS can prove to be the ideal vehicle for investment. However, one should not expect any guaranteed returns from CPOS at any given time.
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#1
Read the scheme information document carefully.
#2
Assess whether Capital Protection Oriented Schemes are a fit with your overall financial plan.
#3
Remember, CPOS do not offer guaranteed returns.
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