Capital protection funds: What’s in it for risk-seeking investors?

Capital protection funds: What’s in it for risk-seeking investors?


Asset prices have been wobbly during the recent months. This has led many investors to consider taking exposure to products that offer downside protection. Capital protection fund is one such product available to retail investors. Are such funds optimal investments?

This article explains the structure of capital protection funds. It also discusses how such funds sit within a portfolio and shows why such exposure can be considered by even the risk-seeking investors.

The structure


Capital protection funds are structured products designed to attract risk-averse investors to the stock market. In developed countries, such funds offer capital guarantee with some upside participation.

In India, these are closed-end funds that offer capital protection, without a guarantee.

The capital protection comes from the fund’s exposure to typically zero-coupon bonds (also called as zeros). Suppose an investor buys units worth Rs 50,000. Assuming an eight per cent yield on the zeros, the fund will require Rs 39,690 to earn Rs 50,000 in three years to protect the investor’s capital. This leaves the fund Rs 10,310 now to invest in the equity market for upside participation.

The capital protection enables risk-averse investors to expose their portfolio to the equity market. Such funds, because of their exposure to zeros, can also form part of the asset allocation decision for risk-seeking investors. Here is how.

Efficient portfolio?


Suppose a risk-seeking investor decides to allocate 40 per cent to stocks, 30 per cent to bonds and 30 per cent to alternative assets. The asset allocation decision translates into 70 per cent (beta) exposure to the core portfolio and 30 per cent (alpha) exposure to the satellite portfolio.

The bond exposure inside the core runs a price risk. This is the risk that the investor has to sell her bond fund holdings at a lower price. The price risk leads to shortfall risk — the risk that the investment will fall short of the required amount at the horizon.

An optimal investment would be buying zeros that matches the liability duration. Suffice it to know here that zeros carry no reinvestment risk (giving it an edge over even fixed maturity plans) and if held till maturity, no price risk as well.

Unfortunately, investors do not have avenues to take exposure to zeros. So, investment in a capital-protected fund can be looked at as two components — exposure to zeros for horizon-matching investments and exposure to equity for upside participation.

Adding such funds to the portfolio can, hence, help risk-seeking investors reduce shortfall risk.

The caveats


Market participants argue that capital protection fund can be easily replicated by investors. An investment in a fixed-deposit or a PPF along with exposure to call options could provide similar payoffs.

Even without considering the tax efficiency and higher cash flows required for a fixed-deposit compared with zeros, the problem is that replicating payoffs requires strict risk management rules. Otherwise, consecutive losses on call options could lead to erosion of capital allocated for equity participation.

That said, capital protection fund also has its share of concerns.

First, a high fee structure acts a deterrent; the typical fee structure is 2.25 per cent of assets under management.

Second, the range of returns within peer funds makes fund selection very important. According to Valueresearchonline.com, the one-year returns on UTI Capital Protection Oriented three-year plan was 11.25 per cent, while Birla Sun Life Capital Protection Oriented three-year plan was 5.85 per cent.

Third, the problem is that such funds do not always offer call-option-like payoffs. Any direct exposure to stocks could expose the fund to downside risk- risk that it may not achieve its capital protection.

Conclusion


Capital-protection funds may be a good investment for retail investors because of its exposure to zeros.

While funds with call-option-like payoffs are optimal within a portfolio context, the high fee structure is a deterrent.