Premium: Building Your Own Capital Protection Plan in 3 Different Ways

Note: This is an archived post of Capital Mind Premium.

“Capital Protection” funds are the new normal, it seems. You invest money that is locked in for three years, and 80% of that money is used to invest in debt instruments. If a Rs. 80 investment yields 9% a year, then a in three years you make 9% x 80 x 3 = Rs. 107 - that is, at least your original amount of Rs. 100 back.

What about the remaining Rs. 20 that is uninvested? They can buy stocks, or buy long term call options, and both will give you some additional upside apart from protecting your capital.

The Downside? No liquidity for three years, because most of these funds limit you from an early exit. And then, there are fund management fees which could eat substantially into the plan; a 2% per year fee will take away 6% from returns.

The Do-It-Yourself Capital Protection Plan

If the idea is to give you a feeling that your money won’t go down, but still retain the upside of equity market returns, then we at Capital Mind would say: Do it your own way.

Let’s check the ways we could create a simple ONE Year portfolio with goals of :

• Capital Protection - let’s not lose base capital

• Liquidity - can I withdraw halfway?

• Low Effort - Don’t ask me to trade every day.

• Tax Efficient - Protect your capital from the government as well.

Method 1: 92% Debt, 8% Anything.

Minimum investment: Rs. 5,000 or so.

With 92% of the money, I would buy a Liquid or Ultra-short term fund (Growth plan only, bought Direct from the fund). These are currently yielding around 9.5%. I believe interest rates will stay up around this level for the next year, so there may not be much risk of this coming down.

(I am invested in SBI Magnum Insta-cash fund and JM Money Manager Super)

The return on 92% of capital, assuming 9% returns, is about 8.3%. So for an investment of Rs. 10000, I put Rs. 9,200 in the short term fund, and that will return Rs. 828 as interest. Added to the principal, I get Rs. 10,028 - my principal remains “protected”.

What about the remaining 8%? This can be invested in multiple ways.

• Buy “momentum” stocks, which will move faster than the Index; stocks like Jubilant Foods, Just Dial and so on.

• Stocks that have a huge upside potential but are mired in controversy - effectively, “option” stocks. This includes stocks like Sintex, Gitanjali Gems, SKS Microfinance. Or those that will benefit from clarity (if it emerges from elections in 2014), such as BHEL, PSU Banks and so on.

• Beaten down sectors like Infrastructure (Lanco, GMR) or Gold finance (Muthoot, Manappuram) where the chances of returns are low, but if they come, they’ll be big.

Whatever you do, even if you lose 100% of this money your capital is protected. But if you lose less - after all, a stock might still have a value after a year - you will see your portfolio give positive returns. Here’s how much:

Goal wise:

• Capital Protection: Excellent.

• Liquidity: Very good. since positions can be exited at any time. Of course there could be losses.

• Effort: Low. Largely one time, in identifying stocks and buying liquid fund.

• Taxes: Growth option of fund means you get to pay taxes only after taking out inflation. Inflation’s 9%. So about 9% returns are tax-free. Equity returns over one year are tax free. (These could change with the budget next year)

The biggest risk is a sudden drop in interest rates, where your returns don’t meet the 9% required. I don’t see this happening, but I’m hardly a great predictor.

Method 2: Nifty ETF Plus Put Option

Minimum Investment: Rs. 3.5 lakh.

Buy a Nifty Exchange Traded Fund like NiftyBeEs, equivalent to 50 times the Nifty value. At the current price of Rs. 612.8, you would buy 500 shares, for about Rs. 306,000.

This investment will grow with the Nifty, and if you assume a dividend yield of 2%, then it will outperform the Nifty by about 2%.

With the remaining money, buy a December 2014 Nifty put option. The price today is about Rs. 560, which for a lot of 50, you would pay Rs. 28,000. The put option pays out if the Nifty is less than 6,500 but gives nothing back if the Nifty is above.

If any money is left over, put it in a liquid fund like in Method 1 above.

The money grows like so. On the X axis is the value of the Nifty one year later (different assumptions).

Goal wise:

• Capital Protection: Very good. There is some interest rate risk, and a small risk that the ETF is illiquid (as you have to sell it after one year).

• Liquidity: Average. The ETF is only reasonably liquid, and the put option might not give you interim liquidity if there are no buyers.

• Effort: Low. Largely one time, in buying ETF, buying an option and buying liquid fund.

• Taxes: Average. Equity returns over one year are tax free. But the put option might have to be justified as a “hedge” to the taxman who will otherwise deem it business income. (These could change with the budget next year)

Method 3: Nifty Spreads

If you’re now wondering how you could do this even better, there is an option with greater effort and a directional bet, keeping capital somewhat protected. You could use Nifty options instead.

Let’s say your view is that the Nifty will slide in the next year, but you want to protect from a potential surge. There could be a call spread position on the Nifty.

This involves:

• Selling a Nifty 5,000 call option at Rs. 1,500.

• Buying a Nifty 6,500 call option at Rs. 560.

• This position will need margin to be maintained at the NSE, and let’s assume all of the premium received (Rs. 940 extra) is retained as margin.

• Your risk is the difference in strikes (1,500) minus the net premium received (Rs. 940), or Rs. 540.

• With a lot size of 50, you could stand to lose Rs. 27,000 on this strategy.

• To cover that, let’s keep another Rs. 15,000 in cash.

• Instead of buying a pure liquid fund, you could buy LiquidBeEs, a liquid ETF that is on the exchange. This can be offered as margin instead, for the duration of the strategy, and will earn returns alongside. (Talk to your broker about how this can be set up)

Let’s look at how this works out:

Note: The column “5000 Call” is the profit on that position. At Nifty of 3,000, it doesn’t pay out anything (since the Nifty is below the strike), so the profit is the entire premium earned. At Nifty value of 7,500, it pays out 250

0 (difference between strike and Nifty value) x50 = Rs. 125,000, minus the premium earned of Rs. 75,000, for a net loss of Rs. 50,000.

As you can see, this “protects” capital, but profits on a long term bearish view.

You can do a lot more with options. If you, for instance, had a view that the Nifty would move up, but not above 8,000, you can run a Bull Call Spread strategy of:

• Buy a 5000 call option (at Rs. 1500) - pay Rs. 1500x50 = Rs. 75,000

• Sell 2 6500 call options (at Rs. 550)- receive Rs. 550x100 = Rs. 55,000

• Your net payment of 25,000 should be augmented with another Rs. 25,000 as excess margin

• You’ll be safe till Nifty 8,000

Goal wise:

• Capital Protection: Depends on the strategy used. The first one above preserves capital no matter what. The second one will lose money after Nifty crosses 8,000.

• **Liquidity: **Average - long term option positions might not be very liquid.

• Effort: High. You may take time to enter the options positions. You might have to speak to your broker about margins and offer the liquid fund against your positions.

• Taxes: Gains will be taxed as business income; no taxman will believe this is a hedge! However it’s good for those will business losses to offset.

More such positions can be constructed using options and futures. In one example I wrote about in 2010, you could quite easily build a structured product that gives you 1.1x of the Nifty return on your capital on the upside, and on the downside, 100% of capital is protected.

But Don’t Be Fooled

Capital protection by itself is a misnomer. If your money isn’t growing by inflation (9%) you are losing money. But not many of us find this easily acceptable - that we have to run just to be in the same place.

If you’re attracted to “Capital Protection”, there are ways you can do this yourself and with a far lower cost than any mutual fund can give you. The best way to protect capital, though, is to stuff it in a mattress. But that won’t allow you to sleep well at night.

Disclaimer

Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.