How many times have you come across investors who lost their money because of a sudden drop in the stock markets? Be it their investments in stock markets directly or through mutual funds they have lost their money.

This happened because most of their investments were directly linked to the stock markets, that is, all their eggs were put in one basket, equity. When stock markets fall the value of such investments drop. However, there is a way out.

There are mutual fund schemes available in the market, popularly known as capital protection funds that will at least protect your initial investments (though this is not guaranteed) while trying to earn some returns on it. However, one must remember that they are long-term funds.

Who should invest in capital protection funds

This is because over a long horizon of 30-40 years, stocks generally see excellent returns but over a shorter horizon of 2-3 years they can be very volatile. For investors with that shorter horizon, investing in stocks may be quite risky.

Capital protection funds are aimed at such investors: they invest mostly in relatively safe debt (where a certain minimum return is assured) but have a limited exposure to stock markets to benefit from their (possibly) higher returns.

The main function of capital protection funds is to protect your principal amount and generate a reasonable rate of return. If you are an investor with not so great risk appetite and will be happy with returns that at least beat inflation then capital protection is all for you.

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In India capital protection funds have been available since 2006. Franklin Templeton Investments (India) launched first such scheme in India that year. The same fund house launched a second fund this year in April. Capital protection funds have become quite trendy and there are several more in the works by UTI, Standard Chartered and SBI among others.

How these funds work

Typically capital protection funds have a lock-in period of 3-5 years (period during which you cannot sell your units from such schemes) so that investors cannot withdraw their investments before then. The initial minimum investment is generally around Rs 10,000. Around 70-80 per cent of the fund will be invested in debt and the rest is invested in equity.

The basic idea is that the debt component will earn a sufficient return by the maturity period to return at least the initial investment. The 20-30 per cent that is invested in equity will provide the capital appreciation.

A simple example helps us understand the advantages and disadvantage of such funds.

Suppose you invest Rs 10,000 in such a fund, which has a lock-in period of 3 years and invests 80 per cent in debt and 20 per cent in equity. Let's suppose the debt portion earns about 8 per cent per annum; this means that the Rs 8,000 invested there will appreciate to around Rs 10,000 in three years' time, and 'protects' your initial capital investment.

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Now suppose the equity markets do really well and rise by 100 per cent over three years, that is, around 26 per cent per annum.  This means that the equity portion of the fund will rise from Rs 2,000 to Rs 4,000. Your initial investment will rise from Rs 10,000 to Rs 14,000, which is about a 12 per cent annual return. This is clearly better than just investing in debt. Of course your return would have been higher if you had invested more in equity.

Some minor irritants

The flip side is that equity isn't guaranteed to do well. Suppose the equity markets had fallen by 20 per cent over three years while the debt continued to earn an annual return of 8 per cent. Then the equity portion of your investment will fall from Rs 2,000 to Rs 1,600 and your total investment will rise from Rs 10,000 to Rs 11,600, that is, around a 5 per cent annual return. Clearly you would do worse if you had invested more in equity.

So the bottom line is that capital protection funds will provide a bit of the upside from a rising stock market while protecting from most of the downside of a falling market.

There are some restrictions imposed on capital protection funds by the SEBI (Securities and Exchange Board of India) in order to protect investors.

Such funds need to have their investment portfolios rated by a credit rating agency (like CRISIL, ICRA etc analyse the debt issued by companies and rate them on the basis of their safety) approved by the market regulator Securities and Exchange Board of India, SEBI. These ratings are reviewed every quarter and furthermore the debt component can only be invested in securities with the highest investment grade, which is the safest.

Investor beware

Despite these regulations, it's important to understand that capital protection funds don't offer a legal guarantee of returning your capital like fixed deposits. With competent management they are highly likely to see at least a positive return but there are still risks associated with the debt component of these funds.

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The two main risks are known as interest-rate risk and credit risk.

The first means that if interest rates rise in the economy, existing debt-based products will become less attractive and therefore fall in price (price of a debt instrument like bond is inversely proportional to interest rates; if rates increase prices decrease resulting in drop in price).

The second is that there is always a chance that the debt issuer may default.  It is exactly for this reason that capital protection funds have to invest I debt that is approved by rating agencies. A well-managed fund will minimise these two risks.

So, in a nutshell, if you are interested in a financial product that isn't too risky but provides some exposure to stock markets, you might want to consider capital protection funds.