Mutual Fund- FAQs
General
Money Market Mutual Funds(MMMFs)
Equity Linked Savings Schemes(ELSS)
Systematic Investments Plans(SIPs)
Fixed Maturity Plans(FMPs)
Capital Protection-Oriented Funds(CPFs)Gold Exchange Trade Funds(GETs)
Capital protection-oriented funds (CPFs)
What are CPFs?
CPFs are funds where the structure of the scheme, with or without external support, ensures protection of the original investment at the scheme’s maturity. In India, capital protection has to be ensured by the scheme’s portfolio characteristics; third party protection is currently not permitted. CPFs are attractive opportunities for investors looking to enhance yield on their portfolios through exposure to risky asset classes such as equity, and yet seeking assurance on the protection of principal. CPFs offer a platform to risk-averse investors who wish to participate in the upturns in equity markets, but at the same time, do not want to suffer erosion in the value of the invested amount. The CPF’s structure and the performance of the debt and equity markets are factors that determine the returns on investments.
What are the highlights of SEBI’s regulation pertaining to CPFs?
SEBI has issued detailed guidelines pertaining to the launch of CPFs in India. SEBI defines a capital protection-oriented scheme as “a mutual fund scheme which is designated as such and which endeavours to protect the capital invested therein through suitable orientation of its portfolio structure.” SEBI stipulates that the CPFs launched be close-ended, and that AMCs do not repurchase units before the end of the maturity period. Debt investments in the case of CPFs must be in the highest-rated investment grade papers. Another pre-condition to the launch of CPFs by AMCs is that the scheme’s units be rated by a registered credit rating agency, from the perspective of the portfolio’s ability to protect the capital invested therein. This rating must be reviewed on a quarterly basis. Further, the trustees are required to continuously monitor the structure of the portfolio of the CPF and report the same in half-yearly trustee reports. The AMC is required to report the same in its bi-monthly compliance test report to SEBI.
How does a CPF’s structure ensure capital protection to investors?
CPFs are schemes with underlying portfolios structured in such manner as to ensure capital protection to investors. There are four broad ways in which capital protection can be ensured. They are:
· Static Hedge: Here, capital protection is provided solely through the debt portfolio. Put simply, the debt portfolio invested matures to the capital value (initial consideration) at the end of the scheme. The remainder (the difference between the capital raised and present value of capital) is invested in equity, which could provide the possible upside to the investors. Investments in debt instruments are typically done on a held to maturity (HTM) basis, thereby negating the impact of market risk on account of interest rate movements. Also, since the debt investments will be in fixed-income securities of very good credit quality, the risk of default is mitigated. Appreciation in the equity component constitutes additional returns to investors.
· Dynamic Hedge: Here, capital protection is provided through a mix of debt and equity. An amount slightly lower than the present value of the protected principal is invested in debt and the remainder, in equity. A combination of the maturity value of the debt portfolio and certain minimum equity component ensures capital protection. In this case, contributions from the equity portfolio are required to ensure capital protection. A covenant to switch back that much equity allocation to debt which together with interest thereon will provide capital protection at maturity on the breach of a pre-determined tolerance level is incorporated. The initial allocation to debt will be lower than in the case of static hedge. The upside will however be higher in the case of dynamic hedge than in the case of static hedge. The downside will be nil in both cases if the scheme warranties are diligently adhered to.
· Constant proportion portfolio insurance (CPPI) is a form of continuous dynamic hedging that was introduced by Fischer Black and Robert Jones of Goldman Sachs in 1986. CPPI is a popular, broadly-applicable and efficient model of portfolio insurance. Globally, the transactions of most hedge fund-linked protection-oriented securities are structured using the CPPI model. Some key advantages of the model are that it does not involve investments in options, is suitable for portfolios consisting of all types of marketable securities, and is relatively simple and easy to understand.
The CPPI strategy maintains a portfolio’s risk exposure at a constant multiple of the excess of wealth in the portfolio over a pre-defined floor level. CPPI allocates portfolio wealth between two assets; a risky asset (assumed to be equity) and a risk-free asset (assumed to be debt), in order to maintain a constant risk exposure. The risk-free asset (consisting typically of high-quality fixed income securities) is expected to earn an acceptable minimum, usually at least the risk-free rate. The risky asset is expected to earn a higher rate of return than the risk free asset. The quantum of exposure to be taken in the risky asset is computed by means of a multiplier. This indicates how many times the excess of wealth in the portfolio over a pre-defined floor level is invested in the risky asset.
Should the risky asset increase in value, more of the portfolio is invested in this asset in an effort to take advantage of the rising asset values. If the risky asset declines in value, the portfolio is rebalanced to reflect an increased weight in the risk free asset. The portfolio’s funds are thus constantly rebalanced (at daily/weekly/fortnightly intervals) to reflect the performance of the risky asset and to maintain a constant risk exposure. The exposure to risky assets is always maintained at levels such that the fund manager can, at short notice, convert the entire risky asset into risk-free investments up to an overall predetermined floor, thus ensuring the minimum, specified payoff at maturity.
· Dynamic Portfolio Insurance (DPI) is a variant of CPPI and allows the fund manager to dynamically change the multiplier, depending on the outlook on the volatility of the risky asset. The multiplier could be low when markets are volatile and high when the markets are stable.
What are capital-guaranteed funds (CGFs)?
CGFs are a variant of CPFs with a guarantee feature embedded in the scheme. In the case of CGFs, the AMC is bound to return the guaranteed amount to the investor if the structure fails to ensure capital protection. This guarantee may also be provided by a third party on payment of a fee. Regardless of how the fund performs at the end of the maturity period, the investor will thus recover at least the guaranteed amount.
Are CGFs permitted in India?
No, SEBI permits no guarantee in India. In its regulations, SEBI states that the orientation towards protection of capital should originate from the scheme’s portfolio structure and not from a bank guarantee or insurance cover. The CPF therefore has to be structured in such a manner that its portfolio constitution ensures protection of the original investment on the scheme’s maturity.
What are the key risks in CPFs?
The key risks in CPFs are the following:
· Credit risk: This refers to the risk of default of the debt instruments held in the portfolio. Current SEBI regulations also restrict CPFs from investing in debt instruments rated below ‘AAA.’
· Reinvestment risk: As interest rates vary, interim cash flows from interest-bearing debt instruments may be reinvested at a lower yield than the original yield.
· Float risk: The structure may have a lower yield than projected if there are delays in deployment, or if the debt instruments are not co–terminus with the scheme maturity.
· Liquidity risk: Liquidity concerns can become impediments in the case of both debt and equity securities.
· Transaction costs: Frequent churning between debt and equity on every rebalancing date, may lead to increased transaction costs.
Is there a surveillance process for CPFs?
Rating agencies will monitor all assigned CPF ratings on a quarterly basis as per SEBI guidelines. As part of this exercise, the rating agencies will seek information from the respective AMCs in a pre-specified format. Using the information thus obtained, the rating agencies will analyse the probability of the portfolio value falling below the initially-contracted principal value, and of investors getting their money back in full.