Construct Your Own Fund

Construct Your Own Fund

By Dhirendra Kumar | Jul 29, 2009

Of all the things that one must learn to become a seasoned investor, the hardest is the ability to take losses. Periodic ups and downs are part of the equity investment process, whether it’s direct investment in stocks, or through equity funds. Still, this is something that many investors can never get used to. It’s an integral part of many investors’ psyche and there’s nothing that can be done about it, except to have investment products that try and deal with it. Or, as I’ll just explain, you can do this yourself by understanding clearly what the risks are and how to mitigate them.

In many parts of the world, equity mutual funds with capital protection are a very popular product. 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 you making losses. These are all closed-end funds and the capital-protection is there only if you invest in the new fund offer (NFO) and redeem at the end.

The way the capital protection works 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. Let’s say a fund collects Rs 100 crore and its tenure is five years. The goal of the fund is to ensure that at redemption, its assets are no less than 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.

And what happens if the debt portfolio has a default or some other problem? In all such funds, ‘capital protection’ is a goal and not an obligation. By law, funds are not allowed to offer guarantees and the Securities and Exchange Board of India (SEBI) 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 a systematic investment plan (SIP) — you’ll just have to wait for a fund company to launch such a fund.

Fortunately, it’s easy for an investor to construct a genuine capital-guaranteed fund himself. Here’s what you should do. Go to the nearest post office and replicate the fund manager’s strategy that I’ve described above. The post office will pay you 7.5 per cent compounded quarterly so for a five year period so you can deposit 69 per cent and have 31 per cent left over for equity investment. The equity part can be invested in any good large cap equity fund and that’s that, you have your very own home-made capital-protection fund.

Not just that, this home-made capital protection fund is actually way better than the factory-made ones on three crucial parameters. One, the equity part is liquid. Two, the equity part is exempt from capital gains tax. And three, the capital-protection is genuine, underwritten by the Government of India. Not just that, you can also construct an SIP-style version of this fund by using the post office’s Recurring Deposit scheme instead of its Time Deposit scheme.

What more could you ask for?