Maximum Gain with Minimum Risk

Of the total population that saves and invests, only a very tiny fraction ever invests in any asset that is backed by equity. Given that equity-backed investments provide better returns, there is no other reason for this except that equity carries a substantial risk of loss. Losses are integral to equity investing, and that's something that investors can never get used to. This inevitably leads to what amounts to the holy grail of financial products – if equity could be packaged in such a way that the risk of loss could be eliminated, then such a product would be extremely attractive.

In many countries, equity funds which can protect the original capital are popular products. In India too, there are a handful of such mutual funds that promise to get you some of the benefits of equity investment while ensuring that there's no chance of the value of your investment falling below the original sum you invested. There are existing funds from Franklin Templeton and UTI, and Birla Sun Life has just launched a couple of such funds, one of three years tenure and another of five years. These are all closed-end funds and the capital-protection is there only if you invest in the NFO and redeem at the end.

The way capital protection works in such funds is that the fund manager puts away in safe debt instruments enough assets so that at least par value can be delivered at the time of redemption. For example, consider a fund that collects Rs 100 crore from investor for a tenure of five years. The basic capital protection goal of the fund is to ensure that at redemption, it has at least the original Rs 100 crore. So what the fund manager has to do is to construct a quality debt portfolio that matures around the same time as the fund's redemption. Now, let's say that that such a debt portfolio will yield 7 per cent over that period. This means that if the fund manager invests Rs 71.3 crore in this debt portfolio, he can be assured of having at least Rs 100 crore to meet the minimum redemption value. This leaves him with Rs 28.7 crore to invest in equity and enhance his investors' returns. Actual funds can change the recipe a bit but this is the basic concept.

It's important to note that these funds are not 'capital guaranteed' but only capital-protection 'oriented'. In all such funds, the 'capital protection' is a goal and not an obligation. By law, funds are not allowed to offer guarantees and SEBI's rules regarding such funds term them as 'Capital Protection Oriented' funds. The 'oriented' part makes it a sort of a best-effort exercise. Also, their closed-end nature means that you can't invest whenever you want to or in an SIP-you'll just have to wait for a fund company to launch such a fund.

In India, the appeal of such products is limited because of the supply of high yielding fixed income options, some of them with genuine government-backed guarantees. Here's how to use one such option-the post office deposit to get all the benefits of a genuine capital-guaranteed (not oriented) fund. All you have to do is to replicate the above strategy with the government's post office deposit. This pays you an interest of 7.5 per cent per annum, compounded quarterly. This means that of the total amount you'd like to deposit for five years, you should put 69 percent in the post office and the rest in any good open-end large cap equity fund.

Not only will this arrangement give you a government-backed capital guarantee, but the equity part will actually be liquid. Moreover, you could actually deposit the money in the post office's monthly income scheme (8% returns) and invest the monthly income in an SIP. This would combine the advantages of an SIP with capital guarantee.