Monday, February 2, 2009

Capital protected is NOT guaranteed

The terms capital protected and capital guaranteed came to light when news of defaulting Lehman Minibonds surfaced in 2007. Frankly speaking, I was not aware of their differences only until recently. I have finished reading Fundsupermart latest quarterly magazine. There is a good article inside that explains the differences and origins of capital protected and capital guaranteed funds. I think it’s good to summarise and share it here.

Capital ProtectedCapital Guaranteed
Risk of Loss Upon MaturityYesGenerally No
Potential ReturnsHigherLower

The table above gives an overall picture of their differences. As everyone should know by now that risk and return go hand in hand. In order to achieve higher return, the product has to be more risky in nature. In short, a product which is capital guaranteed will have lower potential return than a product that is not guaranteed in capital ie a capital protected product, unit trust, endowment, etc.

But what does capital guaranteed fund means? MAS has provided some guidelines for capital guaranteed funds. Below are extractions of the guidelines:

2. Capital guaranteed funds are unit trusts that promise to return the full
invested, usually after a certain period of time or at particular
points of time.

3. Under the guidelines, every capital guaranteed
fund must have a qualified guarantor, which is usually a bank of sound financial

Therefore the keywords that you need to take note are return of full principal on maturity and the guarantee must be made by a bank of good standing. Even a 50% guarantee on principal is not considered a guaranteed fund.

Now what is a capital protected fund? First of all, you need to be aware that capital protected does not equate to a guarantee of capital. From the table, you can see that such funds may face risk of loss of capital upon maturity. In other words, there is no guarantee that you will get back your invested capital.

In a capital guaranteed fund, the principal is usually guaranteed by a third party guarantor. However in a capital protected fund, the principal is guaranteed by the issuer of the product itself. The capital protection in the fund may involve a variety of complicated instruments including Collaterised Debt Obligations (CDOs), debt securities, options, swaps, deposits, etc. Protection with a variety of instruments is supposed to limit the loss of the fund should there be any defaults in the securities. That is how the name protection comes about.

So in future, don’t take the impression that a capital protected product would not make you lose money upon maturity. Always think of risk and return that will definitely go hand in hand together. You can also think 2.5% risk free CPF rate as a benchmark. Any products that can offer better rate than that have some risks associated with it.

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