Capital protected fund

INTRODUCTION: In pressing times, we recede into our homes and shut our windows tight. It is difficult to take chances, and easy to lose perspective of how to protect ourselves and our property. But look to the hard-working ants for advice - when rain is in the forecast, they charge forth into the world to gather supplies, and continue their toil each time the downpour lets up.
Similarly, in the current economic situation, when salaries are low and inflation on the rise, we require an avenue to prevent erosion of purchasing power and make our hard-earned money go a long way. In such a scenario, one of the most promising investment avenues to outperform inflation is the stock market. The Karachi Stock Exchange, over the last ten years, has outperformed all asset classes including gold, dollar and NSS certificates, and has beaten inflation by a wide margin to give one of the highest annual return figures in all of East Asia.
It is true that stock markets in general are volatile - but the intelligent investor sees opportunities even where others see only adversity. As Albert Einstein is reputed to have said, "In the middle of difficulty, lies opportunity." The legendary investor Warren Buffett, founder & CEO of Berkshire Hathaway, is known to have made his fortune in bear markets. Hence, if you want to save and build your wealth, now is the time to start investing wisely.
The Need for Capital Protected Investment Avenues Investors experience severe anxiety during volatile times. This anxiety and pessimism, often causes an investor to take suboptimal investment decisions. How many of us at some time or the other have bought few shares, seen a steep decline in price, and sold them off, losing both our money and our faith in the markets? Therefore, investors seek the comfort of investing in a portfolio which has a growth potential of equities along with assurance of getting their initial investment back.
To address this need, many Asset Management Companies (AMCs) in Pakistan have launched Equity based Capital Protected mutual fund schemes. Most of these schemes deploy a conventional capital protection strategy of investinga significant portion of their assets (80%-85%) in bank deposits/government securities, for capital protection at maturity, while the remaining assets (15%-20%) are invested in high yielding assets such as equities for capital growth. This asset allocation between equities and fixed income instruments remains fixed throughout the life of the scheme.
While these schemes manage to return your invested capital at maturity, they actually fail to earn desired level of returns for the investors. This is mainly because, when stock market is rising, the returns of these conventionally structured capital protected schemes do not improve significantly due to their fixed and very low exposure in equities.
Hence, there still remains a vacuum for an investment avenue that can offer investors maximum upside potential of the stock market along with capital protection. There is a need, then, for something more. One revolutionary strategy makes it possible to have both: the CPPI Methodology introduced by Fischer Black and Robert Jones of Goldman Sachs in 1986
CONSTANT PROPORTION PORTFOLIO INSURANCE (CPPI) CPPI Methodology is a well reputed dynamic asset allocation mechanism which allows you to invest up to 100% in the stock market, with full protection of your invested capital. Unlike conventional capital protected schemes, CPPI methodology dynamically allocates your investments between equities and fixed income instruments based on the performance of the stock market. The dynamic asset allocation is aimed at achieving upside participation in equities while simultaneously, aiming to protect downside risk of capital.
As the stock market rises, the methodology allocates more money to the stock market; and as the stock market declines, more money is allocated to fixed income instruments. In an extreme case, if the investment value falls to a pre-defined minimum value, the entire portfolio is withdrawn from stocks and invested in safe fixed income instruments, to provide capital protection at maturity.
Let's illustrate the CPPI mechanism through an example where you are investing Rs 100 in a two-year CPPI product with an initial allocation of Rs 75 in Equity and Rs 25 in Fixed Income securities . On the second day if the market goes up by 2% the investment amount will be Rs 101.5 and Equity allocation will increase to Rs 80.
On the third day if the stock market goes down by 1% the investment amount will decrease to Rs 100.7 and the Equity allocation will reduce to Rs, 78. This daily reallocation will continue as long as the Investment Value is more than the present value of the capital protection amount. If on any day the Investment Value becomes equal to the present value of the capital protection amount then the entire Investment will be moved from Equity to Fixed Income securities to ensure capital protection at maturity
Some CPPI based Funds also have a profit lock-in feature, which provides the opportunity to lock-in some of the gains made from the equity portion, and safeguard these gains from any subsequent decline in the stock market. CPPI Methodology is one of the most popular strategies used internationally for developing capital protected schemes. Renowned institutions like Barclays Capital, Deutsche Bank, Citigroup and HSBC have successfully developed and sold capital protected funds based on this methodology.
CONCLUSION For the intelligent investor in Pakistan, it is time to move on towards more sophisticated, strategic investments that capitalise on the undiscovered opportunities in our nascent equity market. The CPPI methodology is the ideal strategy, which offers potential for high returns through its flexible and responsive approach. Capital Protected Schemes deploying this strategy can reap considerably high returns in rising markets, and provide capital protection at maturity, thus ensuring security of your valuable savings. It is now possible to have the best of both worlds - full security of capital, with ambitious returns on your investment.