Are you ready to pay for guarantees?

To make sure that the money you invest comes back to you while you get to dabble into the markets sounds good. But there are a few costs that such a guarantee may entail — performance and features and in some even high charges. Abhishek Anand & Deepti Bhaskaran report. How capital safety products are fairing

To make sure that the money you invest comes back to you while you get to dabble into the markets sounds good. But there are a few costs that such a guarantee may entail — performance and features and in some even high charges. We found that out by scanning capital protection products among mutual funds and unit-linked insurance plans (ULIPs).

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Mutual funds
The highest that any capital protection fund has delivered last year is just 5.88% (Franklin Templeton Capital Safety 5 Yrs), according to data from Value Research, a mutual funds tracker. The least was 3.09% (Sundaram Capital Protection Oriented Series I 5 Yrs).

Compare this with the rate of inflation for 2010-11, which has been above 9%, and your real rate of return turns negative. The real rate of return is the nominal rate of return minus the inflation rate. Even bank fixed deposits (FDs) have fared better than capital protection funds over the past year, though FDs’ real returns are negative, too. A year ago, banks were offering interest rates of around 6.5-7% for a year.

Why poor performance: In their bid to protect the investors’ initial capital, these funds predominantly — at least 70-80% — invest in bonds. The performance of bonds is inversely related to interest rates movement. In a rising interest rate scenario, bonds tend to perform badly. “Capital protection funds also invest part of their corpus in equities and since equities have hardly yielded any return in the last one year or so, that too has impacted the performance of these funds,” says Kartik Jhaveri, founder and director, Transcend Consulting (I) Pvt Ltd, a Mumbai-based private wealth management firm. These funds are closed-end and if you stay the course rather than exiting early, your returns would get better. You will have to pay an exit load if you leave the fund before its term and that may drag your return down.

Ulips
Capital guarantee products became popular post 1 September 2010, when the regulator introduced cost caps on Ulips. Capital guarantee in the form of highest net asset value (NAV) caught the fancy of investors. So while your capital is protected, on the upside this plan offers to lock the highest NAV that your fund reaches. While the lure of highest NAV is strong, the fineprint can change the story.

The highest NAV guarantee fund works in a bullish market but since they can switch completely to debt, during a market downturn they shift your funds to debt to lock your gains. If the markets continue to fall, the insurer will shift more and more into debt, which gets reflected in your NAV.

Performance: As the markets continue to stay volatile and more money gets allocated to debt, the fund performance will mirror the returns of a balanced or a debt product, which will get reflected by a much sober NAV. The biggest risk is that the entire corpus can get shifted to debt if the market crashes. It becomes difficult to move back to equity, especially towards the end of the tenor, as the focus then would be on preserving the highest NAV.

Cost: These plans charge you extra for offering the guarantee. Worse, mortality charge and charges on account of a guarantee are outside the regulatory caps purview. Depending on your age, the sum assured and the charge for the guarantee, the advantage of a capital guarantee can actually turn against you.

Here’s an example: Canara HSBC Oriental Bank of Commerce Life Insurance Co. Ltd’s Insure Smart Plan is a 10-year term product that guarantees the highest NAV over the fund’s initial seven years. For this guarantee, it charges 0.35% per annum of the fund value; this is over and above the fund management charge. Assuming you pay R1 lakh for five years for a sum assured of Rs15 lakh, it has a limited premium paying term-and your fund grows at 10%, the plan will give a return of 6.45% in 10 years. According to the regulator, the difference between the gross yield and the net yield can't be more than 3 percentage points, but here the returns have come down on account of the cost on guarantee, which is not within regulatory caps.

Features: A ULIP offering any kind of capital guarantee typically does so only on maturity. So in case you wish to surrender your policy or in case of death, the guarantee will not be available. Also, these policies come for shorter terms, usually 10 years, and with a limited sum assured.

What you should do

Capital guarantee products are for risk-averse investors. But even in the conservative and safer investment stable, there are better products to use. There is Public Provident Fund that gives 8% risk-free return, though its horizon is 15 years. For shorter duration, you could consider FDs if you are in the lower tax bracket. Fixed maturity plans are also an option. But if you can stomach some risk, investing in equity over at least 10 years will automatically insulate your capital from inflation.