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Indian equity markets may not have gone anywhere in several years, but that does not mean there have been no investment opportunities elsewhere, in other asset classes. Do you have a view on oil prices going up or down? Have a view on gold and silver? Have a view on currencies moving one way or another? Have a view on a specific stock or sector within the market? Have a view on any other stock market outside India? Have a view that the market is going to crash and want to take a bet on this view? Have a view on interest rates going up or down? There can be many views on many asset classes and many themes - and many money making opportunities beyond simple products available to retail investors. But, bets will be placed on such views more often than not if there is some downside protection thrown in. Is it therefore possible for you and your client to take a position on any of these themes, and have the comfort of capital protection as well? Welcome to the world of structured products.
What is Structured Product
A structured product, also known as a market-linked product, is a pre-packaged investment strategy based on derivatives such as a single security, an index, debt issuances or even foreign currencies. They can be Principal Protect or Non Principal Protected structure products. Most structured products that are sold in India, have 'principal protection' function as the key, which means that the investor is assured that he will not lose principal amount invested by them subject to conditions of the issue. Structured products are designed to facilitate highly-customised risk-return objectives.
Structured products provide the investor with the ability to tailor their returns to provide capital growth, income or even a combination of the two. Structured products can also be designed to provide positive returns even if the direct investments in a market would have produced a loss.
How does a structured product work?
Let us take the example of a simple Nifty-linked capital protection structure. Say, you invest INR 100 in a product with tenure of 36 months. Of this, INR 80 is invested in debt securities, yielding a return of 7-8% per annum. Thus over a period of 36 months, you could get INR 20 as interest on these debt securities. Hence, this ensures that your capital of INR 100 is protected. The balance of INR 20 available is invested in the Nifty. If the Nifty doubles in 40 months, INR 20 will become INR 40. Thus the value of your INR 100 will be INR 140 at the end of the period giving you an absolute return of 40%. On the other hand, if the Nifty were to fall by say 50%, then INR 20 invested would become INR 10, thereby giving you INR 110 back. This strategy ensures that at any given time, your capital is protected and you will get INR 100 back at the end of 36 months. While this is a simple structure, more complex structures using quantitative strategies could be deployed, depending on the risk profile of the investor to generate higher returns.
Graphical representation of Principal Protected Equity Structured Product
The above example is very basic and simplified structured product idea for understanding purpose only. The same basic structure, when applied to alternative asset classes, allows investors to take a position on a wide variety of assets, with downside protection thrown in. Substitute Nifty with options on commodities, bullion, international equity indices - and you suddenly have a range of investment alternatives that you can now take a view on, seek to capitalise on a move in one direction or another - and yet have your principal protected, if the call goes wrong. Because you are dealing in the world of options, you are not wedded to the notion that the market has to only go up for you to make money. If you believe the market will crash, well buy a structured product whose options seek to play that scenario. If you believe one sector will do either very well or very badly, look to make money from that move - whether up or down.
The central idea behind a structured product investment therefore is to look for opportunities where you believe an asset class will move significantly - one way or another - and seek to make money from that move, with some downside protection thrown in.
Capital Protection Oriented mutual funds vs structured products
Cap-Pro mutual funds in India are in a sense one version of simple structured products, but wrapped within a mutual fund structure. Since they are governed by mutual fund regulations, there are in-built features and restrictions on what you can and cannot do with your options strategy. You can't for example bet on a single stock or sector. You can't for example bet on markets going down. You can't bet on themes beyond the broad market Indian equity index. Cap-Pro funds and a variant, CPPI structures, are discussed in another Jargon Busters - Mutual Fund article - Click Here
Structured products that operate outside of the ambit of mutual funds have a wider spectrum of calls that can be taken. The space is still evolving in India and over time, one would expect many more variants and many more themes to become available in India - just as we see in developed markets.
Structured products in India are issued mainly as debentures with an option appended. Nifty linked debentures are a popular example of a structured product in India. Though marked linked debentures look similar to a Cap-Pro mutual fund, in reality, through a combination of various underlying securities, tenure, participation ratio and trigger limits, structured product ideas can be a lot more complex and a lot more interesting compared to Capital Protection Oriented mutual funds.
Due to the complexity, structured products are not meant for retail investors and are usually offered to high net worth individuals by wealth management firms. Many wealth management firms work closely with issuers to tailor products that they believe will either suit their clients requirements or will capture a strong view on an asset that the firm is convinced about.
Risk Management
The very nature of a structured product - with its downside protection feature - has an embedded risk management feature in it, which makes it very appealing to high net worth investors.
Through structured products, individual client specific needs or expectations can be met e.g If client has huge exposure in single stock or couple of stocks and wants to protect downside in volatile or falling market without selling his holding, he can go for structured products which will compensate him in case of a slide in that stock - thus making him neutral to volatility, and saving on capital gains tax of selling and then re-buying at a lower level.
Portfolio insurance is another important utility of structured products - where you seek to protect yourself against an expected market fall, without taking the risk of selling out your entire portfolio.
Advantages
Structured products help manage risk and return expectations across a wide array of underlying asset classes They enable investments in markets otherwise difficult to access: e.g. oil, commodities, bullion, volatility, etc. Flexible exposure can be tailored to suit a client's portfolio need Adaptable exposure can be configured to reflect prevailing market conditions Customization & Client specific launches, subject to minimum corpus size, usually INR 5 Crores
Disadvantages
Investments are not liquid, extremely limited secondary market transactions Individual components of a Structured Product are not transparent and costs can therefore be high Designed to be held to the end of the term, the benefits, including any protection of capital, only apply at maturity Investors may get back less than they invested if the product is redeemed before maturity or upon maturity if not capital protected If the issuer defaults, you may end up losing the capital. If you get back just your principal at the maturity, then you have suffered a notional loss of interest, as this money could have been used to earn from other avenues such as debt instruments.
Are structured products bad for investors?
Some advisors believe structured products are bad primarily because the cost structure is opaque and often quite high compared to vanilla products. Others believe that structured products serve a need particularly for HNIs who wish to participate in asset classes beyond the ordinary or who seek some form of risk management not normally available in vanilla products. The bottom line therefore is that a structured product that replicates a vanilla low cost offering may not be a great idea, but a fairly designed one that operates in a niche than vanilla products are absent from, could serve the interests of some HNIs.
Key Terms and their characteristics
Underlying
The payout from a Structured Product is linked to the movements in an underlying asset / basket of assets Viz. Equities, Indices, Commodities, Gold, Interest rates, etc.
Participation
The rate at which the change in the value of the underlying is tracked by the product
Different products will offer different levels of participation in the performance of an underlying asset. Generally it is in the range of 50% - 175%
Protection
The degree to which the investor's initial capital is guaranteed at maturity.
Some products will protect some or all of initial investment, which means one can share in the growth of specific markets at a level of risk that suits ones risk appetite
There is typically greater growth potential the more risk one are prepared to take with your capital
Term
Number of years to maturity of the structured product
Typical tenor is around 1 to 3 years. Tenor is represented in "xx/yy" format, for example as "36 / 39 months", where xx indicates the timeline for which the underlying is tracked to determine the payout, and yy is the actual maturity of the Debenture
Underlying Instrument
Debenture, alternatively referred to as Nifty Linked Debentures (NLDs), Equity Linked Debentures (ELDs) and as Non-Convertible Debentures (NCDs)
Typically Non Convertible
Unlike a traditional Debenture that has a predetermined coupon and maturity payouts, the coupon and redemption payouts from these Debentures are determined by a payout formula
Payout formula is a function of the Underlying, and incorporates the investment view of the structure
Debentures are generally listed on of NSE or on BSE
Issuer
Debentures typically issued by Non Banking Financing Companies (NBFCs)
Issued for private placement
Choice of Issuer impacts the credit risk of the Debentures
Principal Protected (PP) Debenture need to be compulsorily rated and listed on the stock exchanges
Non Principal Protected (NON PP) Debenture cannot be listed on the stock exchanges
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !
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