The thud, thud, thud you hear every other day in the stock market should tell you that you need to tweak your investment strategy in 2018. From its peak earlier this year, the Bombay Stock Exchange Sensex has fallen nine per cent, and was perched precariously at just above 33,000 at the time of writing in.

We know what is making the markets skittish: political uncertainties this year and upto the first half of 2019, worries over slippages in the fiscal deficit, and concerns over a rise in interest rates as the US Fed, and our own RBI, fret over inflation. In this period of uncertainty, the markets don’t know whether they should be bullish or bearish. This is one reason why it will stay volatile, and my own Sensex range for this market is a wide 30,000-40,000, with the lower limits being tested on negative political developments (BJP losses in the four major state elections), and the upper limits driven by both good news on the political front and corporate developments, including higher profitability and an improvement in bank balance-sheets during the course of calendar 2018.

In this scenario, one can’t be reckless about investing in stocks, unless we are talking about real long-term investments with horizons beyond three to five years.

While investors can continue to remain in SIPs (systematic investment plans), there is a real prospect of wealth erosion in the short- to medium-term. This is, therefore, a good time to consider investment in various types of capital-protection funds. You can even shift some of your existing investments in equity or equity funds to capital-protection funds. These funds focus on ensuring that the money you invested does not shrink, even if there is not much growth.

Three types of capital protection funds are worth considering.

One is the debt-oriented capital protection fund, which invests the bulk of the corpus in debt, and only a small portion, or the incremental income portion, in equity. Thus, your downside is limited, while you gain if the markets rise at some point. Such capital protection funds usually come with a lock-in, so that the fund does not incur excessive costs by having to buy and sell too much due to inflows or outflows.

The second kind is a pure-debt fund, but with a specific maturity period. Called fixed maturity plans (FMPs), these funds can have tenures of as little as a few months and extend upto three years. The fund invests the money in debt and commercial paper with underlying maturities that correspond to the investment tenure, and so there is no loss in value due to market price depreciation. FMPs also have a tax advantage over fixed deposits, which are fully taxable. In the case of FMPs, you get the benefit of cost indexation, which lowers your effective tax rate.

A third type of capital protection fund is the equity savings scheme (ESS). In ESS, the fund invests about 30-40 per cent in debt, another similar amount in equity, and the balance is used for arbitrage – buying and selling shares and covering the purchases by trading in the futures market – so that the capital is protected. Even though only a third is invested in equity, the arbitrage portion of the investment allows ESS funds to be listed as equity-oriented, and hence eligible for long-term capital gains (LTCG) exemption. Even after the latest Union budget levied 10 per cent long-term capital gains tax on equity, ESS funds are relatively tax-efficient. Some examples of ESSs include HDFC Equity Savings Fund, ICICI Pru Balance Advantage Fund, Kotak Equity Savings Fund, etc. ESS funds have delivered an average of 8-12 per cent annual returns, handily beating inflation. Even with a 10 per cent LTCG tax, ESS funds are tax-efficient and, moreover, they protect your capital better than pure equity schemes. Not that ESS funds can’t lose value, but the losses are lower than pure equity schemes in bear markets.

The broad principles underlying a capital protection fund are simple: keep the bulk of the money in an asset that does not depreciate (or depreciate much), and invest the balance (or future income streams) in equity. An extreme form of capital protection fund would be something you can do yourself.

Take this simple example: If you invest Rs 100 in a bank fixed deposit, or a AAA-rated company fixed deposit, you pay tax on the income, but your capital remains intact. If you now invest the balance income (after tax) in equity, you would have created your own capital protection investment. The fixed portion of the deposit will protect your original capital, while the income invested in equity will give you gains, even large gains over the medium term, that may help you beat inflation. A variant could be to invest in tax-free bonds, where currently yields on market prices are in the range of 6.1-7 per cent. (Be warned, bonds at the higher yield levels are poorly traded, and hence tough to buy). But even at the lower end, remember that this is tax-free income, and hence if you invest the annual income in equity, you would have a capital-protected investment plan.

You may not need a capital protection plan if you are young, and at an early stage in your career. But if you are on the wrong side of 50, and you cannot afford to deplete your investment corpus due to fears of a bear market, capital protection funds are good way to balance your risks. What’s better, you can do it yourself.

(The part of this article was published first in Dainik Bhaskar)

Capital Protection Funds

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