Capital protection fund has its genesis in late 2008 when investors were running away from stock market. Product manufacturers understands investor psyche very well. They knew that they are not running from stock markets but are afraid of losing money on investments. So they come up with their innovation in the form of Capital protection oriented funds. The word capital protection is enough to attract the attention of Investors. Since then there are many mutual fund companies regularly launching Capital protection fund series and collects a handsome sum as investment corpus. But does it really make sense to invest in such funds or investors are falling prey to such seemingly attractive proposition. Let's understand in detail.

What are Capital Protection oriented funds?

How capital protection oriented funds work?

First thing an investor needs to understand is that Do read the title of funds as "Capital protection ORIENTED" which means that there's no guarantee of capital protection in these funds. The portfolio will be oriented towards giving capital protection but is not assured. Though most of the investments are in debt, but investment in debt has its own risks.

Let me explain you the working of Capital protection oriented funds with an example.

Fund A is launched as a Capital protection oriented fund with a close ended tenure of 5 years. The AAA rated debt papers with the same tenure in market is yielding 9% p.a.

Now the structure of fund will be: Rs 65 will be invested in debt papers yielding 9% rate for 5 years, so that it becomes 100 by the time fund matures. The rest Rs 35 will be invested and traded in the equity market to generate the capital appreciation. Let's assume that Equity market gives 10% p.a of returns, then the maturity value of your investment will be 156.37 means you have earned Pre-tax return of 9.37% p.a with protection of capital. The more equity performs the more return the capital protection oriented funds generate.

Are the returns from Capital protection Oriented funds taxable?

Yes. These funds come under taxation of debt funds. The long term capital gain taxation in these funds is 10% without indexation or 20% with Indexation. Indexation helps in improving the net returns, as it leads to adjustment of inflation into the returns.

But you can reduce your tax outgo by designing your own capital protection oriented fund.

Yes, it is true. You can design your own capital protection fund by combining FMPs and Diversified equity mutual fund in your portfolio. Say for e.g. You have Rs 10 lakh to invest for 5 years, but you are afraid of losing capital. You are also looking at some tax efficient investment , than rather than getting into capital protection oriented fund you can design the same structure for your investments yourself. Try to find out the tentative idea on current yield of AAA rated paper and search for FMPs trying to build a portfolio of the same. Let's assume the FMP yield to be 9%. Now with a time horizon of 5 years, you need to invest Rs 6.5 lakh in a FMP expected to yield 9% p.a to get your capital back. (You have to do some maths on finding the present value of investments depending on the interest rates prevailing), the balance amount you can park in some good diversified equity Mutual fund. This way you have designed much efficient tax structure than a capital protection fund. Below table shows the tax calculations.

The above table clearly shows that if you design your own capital protection fund than you can save around Rs 20000/- more on tax payment.

Should you invest in capital protection oriented funds?

Frankly being a financial planner, I always advise on making investments keeping the goal in mind, and I believe that there are many actively managed funds in the mutual funds space which have potential to deliver better returns than Capital protection oriented funds. Then the taxation structure does not attract me, as I can save more on tax by self-designing such portfolio. Those who are in lowest tax bracket may structure the product through bank Fixed deposits. This way they will not lose on liquidity front also.

The capital protection funds are being pitched in various banks as bank fixed deposits and the reason of them pitching like this is your ignorance and their brokerage, which is very good in these funds.