Notwithstanding the current rally in the stock markets, there are many who are still wary of entering the market. They watch the wild gyrations of the stock markets from afar and marvel at the guts of the punters, who play on them and seem to pluck money out of thin air.

Without doubt, bank fixed deposits, RBI bonds, NSCs, etc would comprise a major share of their portfolio. The lure of higher returns from the stocks tempts them, but the unpalatable thought of losing even a single paisa of their hard earned principal make their stomach churn.

This is a major deterrent which forces a person to just sit on the sidelines and watch the game, lamenting his fate.

It is funny but true but these are the investors who actually can use kicker from a stock-induced return. For such investors the newly launched Capital Protection Oriented Schemes are a godsend.

Last year in August, the Securities & Exchange Board of India (Sebi) issued guidelines for these types of funds and asset management companies have queued up for permission to launch schemes in this category.

Do these schemes guarantee capital?

The answer is NO. But it most likely will. Sebi guidelines do not permit AMCs to give any guarantee for the return of capital, but the portfolio of this fund is structured in such a manner as to ensure the safety of capital.

The schemes are so designed that the probability of losing the initial amount invested is virtually nil. The intention of the fund house is to return the Capital and provide a reasonable return.

If there is no overt guarantee, on what basis can we invest?

According to the Sebi norms, capital protection-oriented schemes have to be rated by an agency. The rating indicates the degree of certainty of the timely payment of the scheme's face value.

Most of the schemes launched have got the "AAA(so)" rating from rating agency Crisil. This is the highest rating assigned by the agency under this category. "So" denotes structured obligation.

How is the portfolio designed to ensure the safety of the capital?

There are different ways for this. They are as follows:

Constant Hedge: This is the simplest way to construct a capital protection portfolio. For example, consider a scheme with an initial value of investment of Rs 100 and three years maturity.

If a triple-A rated paper of a company currently gives a yield of 9%, the AMC invests Rs 77.25 in it. This investment is constant and not tampered with much.

The balance Rs 22.75 (100-77.25) is invested in equity. If this amount gives you an annualised return of say 15 per cent for three years, it will add up to Rs 34.55.

This works out to an annualised return of 11 per cent on Rs 100, which is a mindblowing return for a fixed return investor.

Obviously, there is no guarantee that the return from equity will be 15%. The tide could turn against you and the return can be negative. In the event of a negative spiral the downside is protected. The initial investment of Rs 100 at least will be returned.

The return earned will mirror the performance of the equity markets. If the fund managers have picked up superb stocks and the markets have boomed, returns can be extraordinary and vice-versa.

Dynamic Portfolio Insurance: Here too the allocation is between equity and debt and the basic working is similar to that of the Constant Hedge method. A slightly higher allocation is made to equity. In the above example, instead of 22.75 per cent maybe 30 per cent could be invested in equities.

If the value of the portfolio falls below a predetermined tolerance level, then a part of the equity portfolio as required is switched back to debt.

The returns are constantly monitored and the asset allocation is strictly adhered to. Obviously, since the investment in equity is slightly higher, there is a possibility of earning a superior return compared with the first method.

Constant Portfolio Proportion Insurance (CPPI): This is a variant of the above method wherein the allocation to debt in equity is reviewed and rebalanced more often and sometimes everyday.

Floor is the predetermined level to cap downside risk. It is the present value of the maturity amount discounted at the prevailing rate for securities of similar tenure. A constant multiplier (say 2 or 3 or 4) is predetermined for the desired level of stock participation.

Equity component = (market value - floor) X multiplier
Debt component = market value - rebalanced equity component

Taking the same illustration further: Rs.77.25 is the present value of Rs 100 after three years discounted at 9 per cent when the scheme matures.

If the scheme assumes a multiplier of, say, 3, initial allocation will be as follows:

Equity portion: (market value - floor) X multiplier = (100-77.25) X 3 = 68.25
Debt Portion: (market value - equity portion) = 100-68.25 = 31.75

Now on the next rebalancing date, assuming the equity portion grows to 74 and debt remains as it is:

Market value = equity portion + debt portion = 74+31.75 = 105.75

The equity portion will be reworked as follows:

(Market Value - floor) X multiplier = (105.75-77.25) X 3 = 84.60

Debt Portion will be as follows:

Market value - equity portion = 105.75-84.60 = 21.15 & so on.

In booming markets, a higher allocation goes into equities and in bearish times a higher allocation goes to debt.

What happens if portfolio value falls below the floor?

Abroad there are third parties who guarantee the payment of the initial amount invested. But in India, Sebi permits no such guarantee.

The portfolio has to be structured in a way to protect the downside risk. If the scheme is following the CPPI methodology, the multiplier would be kept low to prevent the portfolio value falling below the floor.

What is the exit option?

These are closed-ended schemes and generally they do not permit redemption before maturity. In most of the cases it should be borne in mind that once a cheque is cut, the amount will be returned to you only on maturity. A few schemes have quarterly or six-monthly exit options. Exit load will have to be borne if you exit early.

What is the tax incidence?

Compared with the other fixed return instruments, returns from the capital protection-oriented schemes are tax efficient. Dividends are tax-free in the hands of the investor. Although the AMC has to deduct a dividend distribution tax of 14.025 per cent from individual investors and 22.44% from corporate investors.

Investors in the growth options can enjoy indexation benefits. Long-term capital gains is 11.22 per cent without indexation and 22.44 per cent with indexation. Compared with this, income of investors in a bank fixed deposits is added to their income taxed at the marginal rate applicable to them.

What is the verdict?

If you invest 65-75 per cent in fixed return debt products and the balance in a good equity diversified schemes, then voila! you have your own capital protected scheme.

If you don't want to bother with the hassle, then yes, go ahead and invest. Just don't get suckered by tall claims of fabulous returns by unscrupulous distributors. Returns can be compared with monthly income plans, where the exposure to equity is between 10-30 per cent.

In worst cases, the scheme will protect your capital. If the fund house has expertise in managing debt and equity assets well and if the stock market supports, you may end up with the coveted juicy return without diluting your principal at all.

The writer is head of mutual funds at Derivium Capital & Securities.