A mutual fund ran an advertisement campaign on television recently to promote its Capital Protection Fund. The advertisement goes like this: An elderly man tells his wife that having a second coffee is very difficult with his limited income and rising expenditure. With an investment in a capital protection fund, the senior citizen says that he can afford to have his second cup of coffee.

The sub-text here is that the combination of debt and equity in a capital protection fund help an investor participate in equity returns while also preserving safety of capital. With fresh inflows through equity schemes drying up, fund houses are launching structured debt products to attract fixed deposits investors.

Predominantly close-ended

A capital protection fund invests 75-90 per cent of the assets in debt instruments and the rest in equity to prop up returns. These funds are predominantly close-ended. Based on the period of lock- in, these funds invest in debt securities maturing in line with the lock-in. As the interest accrues, the portion invested in debt grows back to your initial capital value of 100 per cent. The equity part of the fund, if it delivers, is intended to generate capital appreciation.

But have the capital protection funds that are already in operation delivered a good return? The category-average managed by such funds with a three-year lock in period was 6.95 per cent. This compares to 7.0 per cent for pure debt funds and 8.4 per cent for monthly income plans.

How they fared

Of the six funds that have a three-year track record, FT India Capital Safety Fund with five year lock-in clocked a compounded annualised return of 8.6 per cent whereas SBI Capital Protection, the lowest in rankings, generated a return of 4.2 per cent. For investors, a pertinent point to note is that with inflation ruling at 8-9 per cent, these funds have not really protected your purchasing power so far.

For instance, had you invested Rs 1 lakh last year in a capital protection fund, your investment for the one-year period could have appreciated by 4.3 per cent, at best, or 1 per cent, at worst.

Over the last one year, the value of Rs 1 lakh would have eroded by 9 per cent because of inflation, whereas your investment in the above schemes would not have beaten inflation. That goes against the concept of capital protection. Along with capital protection one must also earn a return higher than pure debt schemes.

Evaluate other options

What has worked against such funds over the past three years is the fact that the equity market has not generated positive returns for investors in late 2007 or early 2008. The recent period too has been volatile for equities, with the Nifty losing 10 per cent in value over the past six months. Even though interest rates have increased, performance of such funds has been impacted. With these funds being close-ended, investors will not have options to exit even if they under-perform.

With banks and non convertible debentures offering 10 -11 per cent for a two year period it is better for the retirees and those in the 10 per cent and 20 per cent tax slabs to go with these instruments. Capital protection funds may only be suitable for people with the ability to hold on for five years and the willingness to assume equity market risks. Others should go for deposits or NCDs.

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