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Designer products for deep pockets
Rishi Nathany
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August 27, 2007 10:41 IST

Booming economy, rising income levels, more savvy investors...all these have meant that there is constant pressure on funds and wealth managers to come up with new products to attract investors.

These investment instruments are specially created to meet specific needs of investors, especially the cluster, which is that of high net worth individuals, as their needs cannot be met through the standard financial instruments available in the markets. Normally, such products are offered through the portfolio management schemes route of asset management companies of mutual funds.

How do they work? Commonly, structured products are combinations of stocks, bonds and options put together in one product. Let us look at two standard products, the first being the capital guaranteed product. An investor puts in Rs 100 into a product with a three-year duration. The fund manager buys deep discounted bonds with a maturity value of Rs 100 or slightly more, after three years, say at a present cost of Rs 80.

The rest of the money, after meeting all expenses like fees and costs, is used either for buying equities or for purchasing specially created options with certain conditions attached to them for the payout to be made, called exotic equity options.

For example, they could be binary options, which give full payout if the stock price reaches a certain level and nothing if the stock price remains below that level. In the example, where equities are purchased, the investor gets back invested capital plus market value of equity portion after three years.

This is generally supposed to offer an investor the best of both worlds, that is, capital safety as well as equity participation to a limited extent, thus enhancing overall returns, if equities perform well.

In this example, where options are purchased, and if at any time before three years, the options are sold to meet contingent conditions, the investor gets a high fixed payout, which is linked to the value of the underlying equity.

This could lead to the investor getting greater returns than in the case of holding the options till maturity or conversion. If not, the investor gets back his capital at the end of three years, with or without nominal returns.

By the very nature of the capital guaranteed product, safety of capital is more important than returns. On the other hand, a risk-taker could invest in a product with 80 per cent investment in stocks and the rest in options so that the returns become higher, though this is riskier.

These products meet the investor's objectives like risk aversion. An investor fearing market volatility may want to hedge his equity exposure. There is also fear of capital erosion due to market downsides. Investors also want yield enhancement without the commensurate risk, i.e. a low-risk higher-return product.

They also look for spreading their investments across various assets and asset classes to achieve proper diversification at a low cost. They have extreme flexibility and provide a wide range of choices in terms of product offering and can be tailor-made for HNIs to meet their specific requirements.

These objectives may vary across the spectrum, from capital protection to strategies designed to generate higher returns with higher risk.

Structured products have multiple uses. They can be used as an alternative to a direct investment or as a part of the asset allocation process to reduce risk exposure of a portfolio or to utilise a bullish market trend without taking the downside risk, since the capital is protected in most cases.

They are transparent in relation to the product structure and various terms and conditions, and allow the investor to know beforehand in most cases what the maximum gain or loss could be, including all the costs related to the product.

Another advantage of these products, which invest in equity options, is that they allow the investor to possibly realise his investment objectives with a limited amount of money and risk, which goes into purchasing the options.

However, if the options fulfil the investor's conditions, then whenever that happens, he can get the entire returns, which can even be before the three year period as discussed above.

Therefore, the investor can gain both in terms of time and money in a favourable circumstance and in an unfavourable scenario, gets back invested principal with or without nominal returns.

Sounds like a win-win situation. But hold on. There are a few disadvantages as well. For starters, the complexity of the product would deter most lay investors. Also, if the terms are misinterpreted by the investor, they might get an incorrect notion regarding the payoffs.

Then, one needs to remember that these products do not provide much liquidity as they have a lock-in for the entire tenure for the capital protection clause to apply.

However, despite the disadvantages these are ideal for investors who want to plan out their investment for the long term.

That is, structured capital protected portfolios are an ideal investment tool for pre-retirees or parents planning for children's higher education etc, where capital protection is a must, but a scope for higher returns are also sought.

The writer is director, Touchstone Wealth Planners Powered by
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