Capital Guarantee Fund

What Is a Capital Guarantee Fund?

A capital guarantee fund is an investment in which the investor's principal is shielded from any losses. With a capital guarantee fund, any losses experienced by the underlying investments are instead absorbed by the fund company.

These funds therefore tend to invest the majority of their available capital in very conservative securities to help minimize the likelihood of losses, a move that also limits return. A capital guarantee fund may also utilize derivatives such as options contracts to guarantee against losses, which can also reduce returns due to the cost of purchasing the options.

These funds are pooled investments managed professionally and may also be referred to as "capital-protected funds." These should not be confused with principal protected notes (PPNs), which are a type of structured product that also guarantee against losses, but which are complex and come with unique risks.

How Capital Guarantee Fund Work

Capital guarantee funds essentially provide a risk-free investment. But while the downside is protected from losses, investors in these funds also sacrifice some potential for upside appreciation. Capital guarantee funds are increasingly popular and are now offered globally, including several different types of underlying investments.

In order to minimize the fund's risk of absorbing losses, fund managers will keep the majority of underlying assets conservative in vehicles such as bonds. They may invest a small percentage of higher risk equity securities. Other times, the fund can use options to hedge downside risk, or as a speculative portion to leverage upside.

For instance, one strategy that can be used is to invest in very highly-rated zero-coupon corporate bonds maturing in 10 years. These bonds, since they do not pay regular interest, are sold at a discount and gain value over time, ultimately maturing at face (par) value. Say the face value on these bonds are $1,000 and are issued at a discount in the market at $915 per bond. If the fund has $10 million to invest, it can buy 915x bonds for $9,150,000, which will mature to the initial principal amount of $10 million in 10 year's time. The remaining $850,000 can be invested any way the fund sees fit in order to generate returns. Because this speculative amount remaining only represents 8.5% of the fund's available capital, fund managers tend to use highly leveraged, but limited downside securities such as options or other derivatives.

Investors should do comprehensive due diligence on these funds since they can be structured in different ways and in some cases, only a percentage of capital may be guaranteed against losses.

Important Considerations

While offering a capital guarantee on the investment, capital guarantee funds are generally known for illiquidity. These funds do not offer easy access to invested cash and capital invested will be locked in for various time periods.

Generally, a capital guarantee fund will require that an investor remain invested for a certain number of years, making these investments best for investors with a long-term investment goal. Illiquidity is a primary characteristic of capital guarantee funds because of their structuring. Typically, a capital guarantee fund will use the invested capital to invest in low-risk fixed-income securities, such as bonds, which need time to reach maturity and repay invested principal.

Capital guarantee funds may offer some return advantages for long-term investors comfortable with the investment’s inherent illiquidity. The returns on these funds can indeed be quite a bit higher than savings accounts or money market returns, which also have no potential for loss of principal.

Note, however that the returns generated from these funds are typically taxed as ordinary income rather than capital gains or tax-advantaged dividends. Furthermore, fees can be higher than typical mutual funds, and are charged by the fund to fund the derivative positions used to guarantee the principal returns and minimize risk.

One final consideration is that funds that employ principal protection only usually guarantee the notional amount, and do not account for the effects of inflation over time. Therefore, if you invest $100 today and receive $100 in 10 years time, the actual value of that $100 has declined in terms of purchasing power due to inflation.

Example of a Capital Guarantee Fund

Prudential has been a leader in the capital guarantee funds market. It introduced capital guarantee funds backed by Prudential Retirement Insurance and Annuity Company (PRIAC) with targeted maturity dates through 2025. It also offers capital guarantee funds through defined contribution plans. Additionally, it has a Guaranteed Retirement Income platform from which numerous capital guarantee investments are offered.