Soften Market Blows

Money is like manure. You have to spread it around or it smells.

These famous words by American billionaire Paul J Getty emphasise the need to diversify investments. But how far can you go from equity markets given their attractive long-term returns?

Keeping this in mind, a number of non-banking financial companies(NBFCs) such as Barclays, Deutsche Bank and Bank of America-Merrill Lynch offer structured products that follow an investment strategy based on derivatives. Though the strategy followed differs from product to product and depends on the derivative that is used, a key feature of a majority of these investments is protection of the principal.

BASIC STRUCTURE

Structured products are customised to suit investors’ risk-return objectives. “In simple terms, structured products can be considered as fixed deposits or debt with features of derivatives,” says Nishant Agarwal, director, ASK Wealth Advisors. These are issued in the form of nonconvertible debentures, he says.

The aim of a structured product is to protect the principal and at the same time give returns linked to stocks. Does this mean all your money is invested in the stock mar- ket? The answer is no, as there is no fixed criterion. The issuer can use the money for own business or trading complex derivative products as well.

However, there are structured products that do not offer capital protection features.

THE BENEFITS

Though issues by NBFCs, you can buy structured products from wealth managers. The minimum investment is usually Rs 10 lakh. “A principal-protected structured product enables one to participate in equity market growth with the comfort of capital protection. The other advantage is the lock-in period, usually three years, which keeps emotions out of decisions,”says Agarwal.

The principal protection clause is valid normally only if the investment is held till maturity. The wealth manager may charge 0.5-3% of the amount invested as one-time fee.

“Structured products are the cheapest way to invest in equities. They give investors access to equity while protecting the capital, unlike the conventional options,” says Ashish Kehair, head of private wealth, equity advisory and NRI business at ICICI Securities.

“Over three years, the cost of structured products is less than half of other investments,” says Kehair.

Structured products are listed on exchanges but are not very liquid. Listing gives the buyer the advantage related to long-term capital gains. This is because the sale of a listed security held for 12 months or more attracts long-term capital gains tax, which is just 10%, whereas an unlisted security has to be held for at least three years for it to qualify for long-term capital gains tax.

THE RETURN

However, the big question is the returns. For, nobody will like to invest for just capital protection.“We have examples where clients have made three times the market returns. Some made just 6-7%. It is a good portfolio diversification strategy,” says Agarwal.

Let’s look at how basic debt and equity plans work. Let’s take a scenario where you have Rs 100 for investing in a combination of equity and debt for three years. Assuming a simple interest rate of 10%, if you keep Rs 77 in a fixed deposit, it will grow to Rs 100 in three years, ensuring capital protection. The balance Rs 23 can be invested in the National Stock Exchange Nifty. If the Nifty gives a 30% return in three years, Rs 23 will become Rs 30. Thus, on maturity, the initial investment of Rs 100 will be Rs 130. However, if the Nifty falls 30%, Rs 23 will become Rs 16. The value of the investment on maturity will be Rs 116.

Considering the above example, let’s assume that Rs 100 is invested in a simple capital protection product for three years. Out of this, Rs 77 is invested in debt for three years and grows to Rs 100 on maturity. The balance Rs 23 is used to buy call options, a derivative instrument for which a premium is paid to get the right to buy the Nifty three years later at today’s price.

Let’s assume that the premium for one call option is Rs 11.5. So, with Rs 23, we can buy two call options, implying two times the Nifty returns, or 200% participation in Nifty returns for a notional investment of Rs 100. Now, if the Nifty generates a 30% return in three years, the two call options will give a total return of Rs 60 (Rs 30 from each call option). The maturity value in this case will be Rs 100 from debt plus Rs 60 from options, totalling Rs 160 (as opposed to Rs 130 in the previous example). If the Nifty falls below the level at which the investment was made, the option will expire, leaving the maturity value at Rs 100.

THE RISK

Liquidity risk: Structured products are listed on exchanges but not actively traded. So, for exit, you may have to go through a wealth manager and arrange for redemption, in which case you may end up losing your initial investment as well.

Issuer risk: If the issuer defaults, you may end up losing the capital. But this risk is present in all financial products, say experts.

Notional interest: If you get back just your principal, you have suffered a notional loss of interest, as this money could have been used to earn from other avenues such as debt instruments.

Structured products bring benefits of derivative investing to investors who do not have either access to these products or knowledge about them.