CAPITAL PROTECTION SCHEMES AN INVESTOR S PERSPECTIVE // PRODUCT OVERVIEW // Arvind A Rao, CFP CM Chief Planner -Dreamz Infinite Financial Planners

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1 // PRODUCT OVERVIEW // CAPITAL PROTECTION SCHEMES AN INVESTOR S PERSPECTIVE Arvind A Rao, CFP CM Chief Planner -Dreamz Infinite Financial Planners 66

2 Our friend, Chintamani had a reasonable amount of knowledge, secured from the various financial dailies and weeklies and from the surmounting advertisements appearing in the media, about Mutual Funds in India. Circa 2001, Mr. Chintamani (the protagonist) is lamenting his decision of having invested a majority of his savings in Mutual Funds during the past one year. Our friend, Chintamani had a reasonable amount of knowledge, secured from the various financial dailies and weeklies and from the surmounting advertisements appearing in the media, about Mutual Funds in India. More so, our protagonist was witness to a rising stock market level and continually had a feeling of being missed out in the run for fast money on the Indian bourses. Lack of time and expertise coupled with the convenience of investing lured the risk-averse Chintamani to investing in equities via the Mutual Funds route, commonly referred to as the indirect and safe route to equity markets. He had even been advised by his cautious investor friends not to invest in equities, due to their inherent potential to erode the capital invested. However, Chintamani dismissed these friends, as being too conservative, not interested in making a killing in the stock markets. Post the boom fallout, all these fragments of advice, which now seemed friendly to Chintamani, coupled with the remorse of having lost a substantial sum of his hard earned money in the infamous Tech Boom of 2000, helped strengthen our protagonist s view that stock markets (even through Mutual Funds) is not his cup of tea. Doesn t the above extract echo the sentiments of some of us, who too have burnt our hands in the various scams that our stock markets have been through? Coming to , Chintamani is again in a fix. Post the Tech boom, he kept himself away from the various financial products, linked to the market, keeping in mind the now familiar one-liners like: Mutual Fund investments are subject to market risk or the other one, used judiciously by the Unit Linked Insurance Policies of insurance companies of the premium paid in ULIPs are subject to the investment risks associated with capital markets. Any movement in the stock market is clearly reflected in the performance of an equity fund; the extent to which the fund responds to the movement however depends on various factors like the investment style and the underlying investments made. Adverse market conditions can make investors feel insecure about their investments, leading to distress redemptions (many a times at losses) or even worse it deters them from investing in such avenues, as we saw with our friend above. The reason why our protagonist has turned apprehensive now is the slew witnessed in the financial market among Capital Protection/ Guarantee Schemes. Until a year back, similar kind of schemes were making the investors wary, at the point of investment, about the risk associated with the investment through their one-liners (as above). Today, we have schemes, both amongst Mutual Funds as well as ULIPs, offering capital protection or guarantee respectively. In other words, Chintamani is now wondering which category of investment to choose from amongst the various capital protection schemes available, or which are being floated, in the market today. The brief introduction above is indicative of the fact that today people are having a choice even among schemes offering capital protection. This article envisages helping the readers to be in a finer predicament in making a choice amongst the Capital Protection Schemes offered by the Mutual Funds and the Guaranteed Maturity Value Schemes offered by the Life Insurance companies. Guaranteeing Maturity Value ULIPs A favorable combination of the features of an investment product and an insurance product led to the birth of Unit linked Insurance Policies, which are on a rampage today in the insurance market. They are rightly called as flavor of the season by some industry experts in view of the rising number of policies logged in. We shall not dwell upon the debate of which among the two ULIP or a combination of Mutual Fund plus Term Insurance, suits our portfolio better, because a lot has been deliberated on that issue. Although ULIPs offered a combination of insurance and investment to the investor, a fair amount of anxiety still prevailed with Chintamani due to the potential to lose his money invested, by way of premiums, as the same were invested in the equity markets (the experience of 2000 was still fresh in his minds). Hereafter, some relief came his way, beginning as early as in some cases, around mid A tinge of smile appeared on our friend s face with the introduction of Guaranteed Maturity Value (GMV) or the Premium Guarantee products by various insurance companies. One of the reasons that led to the introduction of such kind of a product was to eliminate the trepidation in the minds of the investors about the uncertainty fluttering around the safety of the premiums invested in an ULIP. The traditional plans (read as endowment plans) offered a fixed maturity value, vis-à-vis the ULIPs, which were not offering the same. 67

3 The term capital protection oriented Scheme, as defined in the regulations, means a mutual fund scheme which is designated as such and which endeavors to protect the capital invested therein through suitable orientation of its portfolio structure. The star attraction of this new genre of ULIPs is that they guarantee the protection of capital invested of their investors, while leaving room to enjoy the market-linked returns, in a bull run. On maturity, the investor gets the higher of the GMV or the market value of their accumulated units. Some of these products offer exposure to equity at as high levels as 80% of the allocable premiums. It is now within Mani s knowledge that the capital invested in a ULIP is secure and is returned to him with a nominal percentage of return on it, plus he has the benefit of participating in the equity markets with a potential to make higher returns, these ULIPs lure him again to invest in the equity markets. But phew, life is not that easy for the anchor of our article, somewhere in mid 2006, he came across articles in various financial dailies and fortnightlies, about the debut of Capital Protection Schemes by Mutual Funds. Protecting Capital Invested Capital Protection Funds Mani is of the opinion that these funds are the new flavour of the Indian Mutual Fund industry and is not very conversant about the nitty gritties of the same. Some of his queries in relation to such funds are being discussed herewith to enable better comprehension of such category of schemes. Birth of a secure star in the world of uncertainty Recently, the Securities Exchange Board of India (SEBI) vide its circular dated 14 August 2006, amended the SEBI (Mutual Fund) Regulations to provide for the launch of Capital Protection oriented Schemes (CPS). The term capital protection oriented Scheme, as defined in the regulations, means a mutual fund scheme which is designated as such and which endeavors to protect the capital invested therein through suitable orientation of its portfolio structure. As the name and the definition suggests, investments in such schemes comes with an endeavor that the investors capital will be safeguarded. Further, SEBI has also mandated that such schemes have to be closed-ended in nature, in other words, investors in these schemes will not have an exit option before maturity. A Word of Caution The regulations expressly state that the mutual funds, 68 launching such kind of schemes, shall disclose in the offer document, Key Information Memorandum as well as in the advertisements that the scheme under offer is oriented towards protection of capital and not with guaranteed returns. In a way, one has to understand that CPS is not similar to the assured return schemes, where in case of the former, the AMC assures the investor of protecting his initial capital investment and not the returns, which is the case with assured return schemes. Further, it is warranted that the proposed portfolio structure indicated in the offer document and KIM must be rated by a SEBI registered credit rating agency from the viewpoint of assessing the degree of certainty for achieving the objective of capital protection. Moreover, the rating should be reviewed on a quarterly basis. The regulations also stipulate the AMC to ensure that the proposed debt component of the portfolio structure has the highest investment grade rating. CPS vs. ULIPS To reiterate, this article is primarily to guide Chintamani in making a choice between a ULIP offering a guaranteed maturity value (which is nothing but the sum total of premiums paid during the tenure of the plan plus a nominal percentage of return, in some cases) and a CPS offering to safeguard his capital invested. It is not contemplated that this article will discuss on the merits or otherwise of investing in a ULIP or a CPS, but will help in taking into account the advantages or otherwise of investing in either of the two. Parameters: The case for illustration: A person (male) aged 25 has two choices: A. Invest Rs. 150,000 in a CPS with a lock in period for 3 years. Or B. Invest Rs. 150,000 in a ULIP for a term of 10 years, with the premium payment term being 3 years and the yearly premium Rs. 50,000. Let s try to conceive the benefits accruing under each of the above options: CPS The criterion for working out the benefits under CPS has been selected based on the information available in the Offer Document (OD) of the latest NFO in this category. Brief highlights for a fund with a 3-year lock-in:

4 Exposure to Equity Class is capped at a maximum of 20% of the assets, whereas that for the Debt instruments begins with a minimum of 80%. For purposes of convenience & simplicity, we have assumed that the AMC adheres to an asset allocation of 80:20 in Debt and Equity respectively. The entry load for subscription during the NFO was Nil. Further, the initial issue expenses (estimated at 3.25% in the OD) have been assumed to be in line with the estimated percentage. Again, the recurring expenses have been assumed at 2.25% (which is the maximum chargeable by an AMC) of the average weekly net assets. It has been inferred that the allocation of assets to debt will return the amount of initial capital at the end of the fund s tenure (which coincides with the theme of the funds in this category). Accordingly, we have calculated the growth in the fund value allocated to equity over a three-year horizon. A growth rate of 10% has been adopted to ensure uniformity with the benefit illustrated under a ULIP (10% is the higher end of the growth rate that can be used by an insurance company in their calculations). The fund value also takes into account the deduction from the fund value on account of the initial issue expenses (which are amortized over the tenure of the fund) and the recurring expenses, both of which are based on the rates, assumed as above. Table A: End of Year Amount (after deduction of expenses) 0 30, , , ,250 Conclusion A: An investor will get Rs. 186,250 (Protected Capital of Rs. 150,000 + market linked gains of Rs. 36,250) at the end of the 3-year tenure. Now s let have a look at what a ULIP s got in store for an investor. ULIPs A ULIP offering a guaranteed maturity value by one of the leading life insurance companies has been selected for calculating the benefits available under the plan. The framework used for the benefit illustration under this plan is that of an investor (male) aged 25, opting for a term of 10 years, with a premium paying term restricted to 3 years. The life insurance cover selected is a low cover one, since the choice of the ULIP is primarily as an investment vehicle. The insurance cover, as per the new & revised guidelines works out to Rs. 250,000. The investible premium has been allocated to the growth fund, which invests the entire corpus in equities (again to maintain consistency with the mutual funds investing in equities for comparison purposes). The Guaranteed Maturity Value under this plan works out to Rs. 169,450, which will be payable at the end of the term. Table B: Year Premium paid Fund Value 1 50,000 43, ,000 98, , ,100 (Please note that although the fund value is worked out at the end of 3 years, as per the regulations, an investor has access to the fund value only after completion of 3 years.) The second step of our calculations for comparison purposes deals with the investment of the balance funds at the end of year 1 and 2. In our example, the investor has funds to the tune of Rs. 150,000 at the time of investment. If only Rs. 50,000 is invested by way of 1 st year premium, we have calculated the growth that accrues to the investor if the unutilized portion of the total corpus is invested in equity mutual funds. Table C: End of year Unutilized Fund Value Next year Net portion (less charges) premium gains 1 50,000 53,825 50,000 3,825 50,000 53,825-3, ,000 57,950 50,000 7,950 Total 15,600 (The growth rate in the equity fund has been maintained at 10% and the fund value is less the recurring charges charged by the AMC.) The amount available for investment out of the unutilized portion available at the end of year 1 has been broken down into 2 parts of Rs. 50,000 each, as the first tranche is available for investment for a period of 1 year, while the other for two years. The total gains on account of the investment of surplus unutilized funds totals to Rs. 15,600. Conclusion B: The amount available to the investor at the end of 3 years in a ULIP will be Rs. 172,700 (Rs. 157,100 on account of the fund value in the ULIP plus Rs. 15,600 on account of the gains made on unutilized funds.) 69

5 Conclusion The fundamental thing that can be founded from both the Conclusions A & B above is that the CPS ranks ahead in terms of accumulated fund value available to the investor at the end of the tenure of the funds. Our exponent now believes that a CPS will give him a higher maturity value (apart from the capital protection offered by each). Behold, there is one more facet to our story. In the various tables presented in the foregoing paragraphs, we have overlooked the fact that the ULIP gives us an insurance cover of Rs. 250,000. In other words, if Chintamani wants to insure his portfolio i.e. ensure that his dependents have access to a fixed amount in his absence, the ULIP scores above the CPS. The impetus behind our reasoning is that if a person s investment rationale for either of the two instruments is to guarantee that a designated amount be available to either him or his dependents for a particular objective or goal, then the said purpose will be served better by a ULIP rather than the CPS, since a ULIP comes with an added advantage of providing an insurance cover. Taking our calculations further, if our dear friend is subject to some unfortunate event during the second year; his dependents have access to only Rs. 186,250 in a CPS, that too made available only at the end of 3 years, due to the close-ended nature of the CPS. On the other hand, a ULIP will provide his dependents with Rs. 250,000 even during the second year. A lesser maturity value is the price that one has to pay for insuring his investments for a guaranteed value in a ULIP vis-à-vis a CPS. To conclude and address the issue of which among the two is better for an investor, I would like to emphasize that my belief that there can be no single solution to this question. I would like to reiterate as it goes the financial planners way, the answer to this million-dollar question would in turn depend on the needs and objectives of the client. EDUCATION, EXAMINATION EXPERIENCE, ETHICS Education for the CFP CM Certification Program is conducted by Authorized Education Providers FPSB India is exploring the possibility of appointing reputed educational institutions to conduct the CFP CM Certification Education Program across India. Interested Educational institutes are requested to contact Ms. Priti Gharat at priti@fpsbindia.org for further details. 70