Security and returns on capital

Mutual funds have become more innovative to cater to the traditional Indian need of capital preservation while earning returns at the same time they have created a scheme-type that offers both.

Most of us choose bank fixed deposits over other investment options because we are afraid of losing precious capital. An interesting alterative is now offered by mutual funds. This comes in the form of preservation of capital, while, at the same time, earning equity returns on a portion of your investment. These are a combination of capital protection schemes-cum-equity schemes.

These schemes invest about 70-75 per cent of the corpus in debt securities, which are rated by rating agencies such as CRISIL, ICRA, etc. The balance 25-30 per cent is invested in equity derivatives, i.e., futures and options. While debt has the required safety, equity derivatives, too, offer safety through hedging, with the potential for better returns.

Profit through hedging

The position in the derivatives market is taken in a manner whereby the fund will earn profits in any market condition – upward market or downward market. Let’s understand this with an example. If the fund expects the market to move upward, it will buy futures and, at the same time, buy put options to hedge its futures position. If the market does move upward, the fund will earn out of its futures position while incurring the premium cost on the put options. However, if the market moves downwards, the fund will lose on its futures position but will earn on its put options, thereby neutralizing the futures loss.

Now let’s understand the fund’s strategy if it expects the market to move downward. In this case, the fund will go short on futures i.e. sell futures, and simultaneously buy call options to hedge its futures position. Now, if the market does move downward as per the fund’s expectation, the fund will profit from its futures position while incurring the premium cost on options. However, if the market moves upward, the fund will lose on its futures position but will gain from options, thereby neutralizing the loss.

These schemes are considered as debt schemes. Accordingly, dividends are received tax-free in the hands of the investors. Short-term capital gains (profits earned on sale of the units held for less than a year) are taxed at the tax rate applicable to the individual on his total income and long-term capital gains (profits earned on sale of the units held for more than a year) are taxed at 10 per cent without indexation (plus surcharge of 10 per cent if the individual’s total income exceeds Rs 10 lakh plus education cess of 2 per cent) or 20 per cent with indexation (plus surcharge of 10 per cent if the individual’s total income exceeds Rs 10 lakh plus education cess of 2 per cent), whichever is lower.

The Kotak Wealth Builder Series 1 is one such scheme presently available for investing. This is a 3-year close-ended debt scheme with a CRISIL AAA rating (which implies highest security) on its debt investments. In addition, to help the investor earn returns, a portion (up to a maximum 30 per cent) of the corpus will be invested in equity derivatives (futures and options). Although it’s a close-ended scheme, it offers liquidity by accepting redemptions on 25th March, 25th June, 25th September and 25th December each year, till the maturity of the scheme at the then-prevailing NAV.

Considering the increasingly complex, yet more and more customized products available for investment, it has become imperative to have the inclination to study investment options before actually undertaking investments.
Capital preservation-cum-return schemes invest about 70-75 per cent of the corpus in debt securities and balance 25-30 per cent in equity derivatives.