Chapter 5 : Novel Portfolio Structures in Mutual Fund Schemes
5.6 Capital Protection Oriented Schemes
Like MIPs and other hybrid funds, Capital Protection Oriented Schemes too, invest in a mix of debt and equity securities. However, the investment philosophy here is different. The portfolio of capital protection oriented schemes is structured to ensure that the investor at least gets back the capital invested.
These schemes are offered as close-ended schemes. Suppose a capital protection oriented scheme of 7 years is offered to investors. If yields on government securities of the same maturity are 8%, then Rs. 58.35 invested today in government securities will grow to Rs. 100 in 7 years.
The mutual fund scheme will therefore allocate 58.35% of the amount collected from investors, to government securities. Sovereign securities do not have a credit risk – and market risk too is eliminated by matching the scheme’s maturity with its investment maturity. Thus, the scheme is in a position to assure investors that they will at least get their capital back at the end of 7 years.
The remaining 41.65% of the investor’s moneys is invested in risky investments like equity. In the worst case, these investments lose their entire value. In such an eventuality, the investor will get only the capital back (through redemption of underlying government securities).
Realistically, the risky investments too will have some realisable value. Thus, the investor gets the capital back, with some additional return.
Such schemes are suitable for investors who want to take some exposure to equity, but without any risk of losing the principal invested.
Points to remember
• Every mutual fund scheme has to disclose its benchmark – a standard against which the scheme’s performance can be compared.
• Fund managers who operate on the mandate of “beating the benchmark” are said to run active schemes or managed schemes. They seek to perform better than the benchmark.
• Comparision of mutual performance with that of its benchmark is called relative performance of schemes.
• The index scheme maintains a portfolio that mirrors the index. Index schemes have a Beta of 1.
• Index schemes are also called passive schemes, because the fund manager does not do stock selection. The investor in a passive scheme benefits through lower investment advisory fees.
• The gap in the performance between the index scheme and the index is called ‘tracking error’. It is caused by
o Timing differences o Liquidity
o Cost
• Exchange Traded Funds started as passive funds (investing as per an index), though active ETFs have been launched abroad. In India, we only have passive ETFs.
• When the scheme is launched, its connection with the index is announced. For instance, 500 ETF units = 1 unit of S&P CNX Nifty.
• ETFs are open-ended funds that can be bought at prices, which vary during the day, and operate with low tracking error.
• ETFs receive funds from investors only during the NFO. Post-NFO, the scheme does not receive funds from investors, thus avoiding the investment timing problems normally associated with index funds.
• Post-NFO, the ETF only sells units against securities. Therefore, an investor who wants to buy ETF units after the NFO needs to offer the requisite Nifty securities, in the same proportion as the index.
• Similarly, the scheme fulfils the need of daily re-purchase of its units, by releasing the requisite Nifty securities. An investor who offers his units for re-purchase will receive Nifty securities in the same proportion as the index - not funds. Therefore, the scheme does not need to maintain liquid funds. This eliminates another reason for the tracking error found in index schemes.
• The mutual fund lists the ETF units in the stock exchange, and appoints identified brokers as ‘market makers’ to facilitate the transactions of small investors. The market maker gives a two-way quote for the ETF units.
• Such the market makers’ transactions with the investors do not go through the books of the scheme, the scheme does not run into the timing differences and liquidity needs that
normal open-ended index funds face. In order to trade in this manner, the investor needs to have a demat account and trading account with the broker.
• The returns in a arbitrage fund are closer to liquid funds, which capture the short term funding cost in the market. It can be higher in volatile market conditions.
• Although arbitrage funds have the returns profile of a debt fund, and are low in risk, they are taxed as equity funds.
• Monthly Income Plans maintain a portfolio that is debt-oriented. Equity component is as low as 15-20%.
• There are occasions where on account of significant decreases in MTM valuation, the scheme will not have the distributable reserves to distribute a dividend. Therefore, investor needs to be clear that there is no guarantee regarding the monthly income.
• FMP invests all its moneys for the same maturity as the scheme’s own maturity. Thus, price risk is eliminated on maturity.
• FMP is a close-ended scheme. Return is not guaranteed, but investor can operate with an indicative yield based on yields in the market and the expense ratio of the scheme. • An FMP investor selling the units before maturity can earn a return higher or lower than
the indicative return.
• Capital Protection Oriented Schemes invest in a mix of debt and equity securities. They are offered as close-ended schemes.