What is a Capital Protection Fund?

6 mins read
by Angel One
A capital protection fund is a type of mutual fund focused on preserving the investors’ capital. Despite prioritising capital preservation, the funds have the potential to deliver modest returns.

Mutual funds are often touted as one of the best ways to invest in the stock market due to their inherent portfolio diversification and a few other benefits. Although that may be true, there’s always the risk of your investment capital losing its value due to adverse market movements and a plethora of other factors. Here’s where a capital protection fund can help. Wondering what it is and why you should invest in it? Continue reading to find out.

What is a Capital Protection Fund?

A capital protection fund is a type of mutual fund that prioritises capital preservation over high returns. This is highly unlike traditional mutual funds, which often aim to deliver market-beating returns through capital appreciation.

One of the primary characteristics of capital protection funds is their structured investment approach. The funds invest in a mix of both debt and equity investments, with a major part of the investors’ capital going towards fixed-income and debt securities. Only the rest of the corpus is invested in the equity segment.

The fixed-income and debt component of the fund ensures that the investors’ capital remains protected even during adverse market conditions, whereas the fund’s equity component aims to generate modest returns.

Furthermore, capital protection funds are closed-end funds, meaning they have a fixed maturity date. Investors cannot redeem their investments before the said maturity date. Depending on the type of fund, the maturity date may be anywhere from 1-5 years.

In Which Assets Do Capital Protection Funds Invest?

Now that you know the meaning of capital protection funds, let’s check out the types of assets that they invest in.

  • Debt Instruments

Capital protection funds invest a significant portion of their capital in fixed-income and debt instruments to ensure capital preservation. The percentage of allocation to debt securities may vary depending on the type of fund you invest in; most funds allocate about 80% to 90% of their corpus towards debt.

Most capital protection funds invest in low-risk, fixed-income securities like Treasury bills, government bonds and AAA-rated corporate bonds. These securities provide stability to the fund and maximise the safety of the invested capital.

  • Equity

The remaining portion of the fund’s corpus, around 10% to 20%, is invested in the equity segment. The fund allocation to the equity segment is at the fund manager’s discretion, meaning that the manager determines the stocks and sectors to invest in based on their experience and research. The limited allocation towards equity helps keep market risk low while simultaneously enabling investors to harness the wealth-creation potential of the stock market.

Why Capital Protection Funds May be Better than Fixed Deposits?

The potential for higher returns is one of the major reasons why capital protection funds are often considered to be better than traditional Fixed Deposits (FDs). The equity component of capital protection funds offers exposure to the wealth creation ability of the stock market while simultaneously minimising the downside risk through strategic asset allocation strategies.

With FDs, however, you only get a fixed return on your investment, with no potential for higher returns. The interest rates offered by fixed deposits are also often lower than the return-generation potential of capital protection funds.

Who Should Invest in Capital Protection Funds?

Conservative investors who prioritise capital preservation over aggressive returns can consider investing in capital protection funds. In addition to a high degree of safety for the invested capital, these funds deliver modest returns over the medium to long term due to their equity component.

Additionally, first-time investors, retired individuals and senior citizens may also find the stability and income-generation potential of capital protection funds attractive. That said, risk-aggressive investors may also choose to invest in capital protection funds to diversify their portfolio risk and provide stability for their investments.

Are Returns on Capital Protection Funds Guaranteed?

Returns are not guaranteed with any kind of market-linked investment option, including capital protection funds. Although these funds invest a significant portion of the corpus in high-quality debt instruments like government bonds, T-bills and highly-rated corporate bonds, they still carry interest and credit risks.

Meanwhile, the equity component of the fund is also subject to market risk and volatility, which can adversely affect performance if the market falls. Even the fund manager’s investment decisions can have a major impact on the returns generated by the fund. Therefore, it is ideal to carefully assess the fund’s track record, investment strategy and risk factors before investing.

How Do I Choose a Capital Protection Fund?

Choosing the right capital protection fund requires thorough research and consideration of several factors. Here’s a quick overview of some of the key factors you must consider when selecting funds. 

  • Investment Objective

Capital preservation is the primary objective of every capital protection fund. However, there may be a few variations in the fund’s investment objective. Therefore, it is advisable to thoroughly read through the fund’s offer documents to ensure that its investment objective matches your goals before investing.

  • Investment Horizon

Capital protection funds are closed-end funds and have different maturity periods. For instance, one fund may have a maturity period of one year, whereas another may mature only after three years. When choosing a fund, you must ensure that its maturity period matches your investment horizon.

  • Risk Profile

The risk factor of capital protection funds may vary depending on their asset allocation percentages and mix. For example, a fund that invests around 20% of its corpus in equity is likely to be more risky than a fund that invests only around 10% of its corpus.

  • Asset Ratings

The asset rating is another major factor to be considered when selecting a capital protection fund. Bonds that are rated AA and AAA tend to be safer compared to bonds that feature low ratings.

  • Asset Allocation

The asset allocation mix of capital protection funds varies depending on factors like the investment objective, risk profile, investment horizon and fund manager’s preferences. The fund’s asset allocation must always match your goals.

  • Expense Ratio

The expense ratio is a fee that mutual funds levy to cover their administration, fund management and marketing costs. High expense ratios can potentially lower your returns. Therefore, it is advisable to pick funds that levy a nominal fee.

Conclusion

Capital protection funds are good investment options for investors who care more about investment safety than high returns. Due to the relatively low exposure to the equity segment, the return generation potential of these funds tends to be modest and lower than that of equity funds. Therefore, it is advisable to set realistic return expectations based on prevailing market conditions.

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FAQs

What is the typical investment horizon for capital protection funds?

Capital protection funds are closed-end funds with a fixed maturity date. The investment horizon for these varies depending on the type of fund you invest in. For instance, some funds may have a 3-year maturity date, whereas others may have a longer maturity date.

How risky are capital protection funds compared to other investment options?

Although capital protection funds prioritise capital preservation, they do carry a level of market and credit risk. However, compared to other types of mutual funds, the risk profile of capital protection funds is low. In fact, it is somewhere between the conservative low-risk fixed-income securities and the aggressive high-risk equity funds.

What factors influence the performance of capital protection funds?

As with any market-linked investment, many factors influence the performance of capital protection funds. The fund manager’s decisions, interest rate changes, the performance of the underlying assets, market volatility and credit risk are a few of the key factors that may impact these funds.

Can investors access their funds before the maturity date of capital protection funds?

No. Since capital protection funds are closed-end funds, they typically come with a fixed maturity period. Investors cannot redeem their investments before the expiration of the stipulated tenure.

Are there any fees associated with investing in capital protection funds?

Yes. The expense ratio, administration fees and stamp duty are some of the common types of charges that you may incur when investing in capital protection funds.