Are Capital protection schemes any good?

Capital protected schemes, usually offered by mutual funds, invest around 75% or so in a fixed income product, while the balance 25% money goes into stocks and derivatives (futures & options). Apart from mutual funds, a lot of broking and banking houses offer fancily named products called ‘structured notes’ that offer ‘capital protection’. These products are excluded from direct regulation and often the guarantees are not incorporated in the prospectus. In a sense, these are ‘collective investment schemes’ (CIS) and the Securities and Exchange Board of India (SEBI) should regulate them.

Typically, there is a lock-in period in which you are stuck for three or more years. In many cases, the principal or capital is returned intact, in nominal terms. In real terms, the amount you get on maturity buys less of everything. So, has your capital really been protected?

The other abuse is that your invested money is diverted to provide for ‘promoter funding’ vis-à-vis structured financing. Fancy stock structures are usually created wherein the interest to be paid by the promoter is passed through, only in part, to the investor. At the end of the maturity period of the structured product, the promoter simply rolls it over or finds a new set of investors who will get deceived. A big chunk of your invested money will be eaten up by the creator of the note (i.e., the investment bank) in the form of fat fees and interests. There’s not much you can do with the lack of disclosures or excess margins undertaken by the company, due to lack of regulation.

The most common arrangements ‘promise’ to keep your capital ‘protected’ and a ‘participation’ in returns so long as some index (or price of the stock or commodity) remain within a particular range over the period of the instrument. Hence, when the price breaches the range on either side, returns vanish. The structures are often complex and involve different events and price triggers. However, at the end of three stressful years, the investor is unlikely to get returns higher than any fixed-income investment. Do you think in the next couple of years, you see returns of over 10%-12% with reasonable certainty? If not, how will the producer of a structured product generate returns? He is merely taking your money, putting enough money into a fixed deposit or something that will give your nominal principal as the maturity amount and gamble with the rest.

If you could understand the structured products (read: capital protection), you will not fall for it. The next time a broker or adviser comes to you with a ‘capital protected’ paper, first ask him to ‘protect’ the capital by linking it to the inflation index and guaranteeing the return. Second, ask him whether there is regulatory approval for it. Without such approval, you have no hope of complaining to a regulator, should something go wrong.

If you are lucky, you will make some money on this part. In case you lose everything, at least you have ‘protected’ your capital.

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