Structured Equity Products

First things first – daughter gets through the national round of the spelling bee that was held in Kolkata. International round is next.

Yesterday, someone asked me to analyse a structured equity product which the wealth management group of a well known private bank had pushed for his consideration and possible investment. This was a “structured” equity linked debenture with a pay-out in the form of a knock out barrier option. If I have not lost you yet and if you aren’t KO’d, you may want to take a peep at the term sheet here. In a nutshell, what this instrument is saying is that it’ll pay you regardless of the NIFTY tanking down. If on any of the predefined monthly observation dates, the NIFTY breaches a preset barrier, then a knock out event would have happened and investors will get a fixed return of 27.5% for 24 months.  This is equivalent to investing in a fixed income instrument (bond) that gives an annual return of 11.4%. Note that with QE2, and a new wave of cheap US money expected to flood our markets the chances of the barrier getting knocked out in the short term remains extremely high. so then all that this means is that you are holding a pure fixed income instrument. The hastily scribbled payoff diagram above tries to show what I think this gives us.

“Structured” equity notes seems to be an INR 15,000 crore industry having been introduced only 4 years back in the Indian market. These class of products are quite popular in Asia and with increasing volatility expected due to increasing wads of hot money coming down to Asia, the popularity of such instruments should grow. That is really a problem since it does not seem cool to buy these things. Why? Because these are just plain and simple fixed income instruments at heart masquerading as sexy and exotic equity junkets. The annual yield of 11.4% really does not look quite cool when one considers A) the prospect of interest rates rising locally as the RBI grapples to control inflation and B) the management fee of 2 – 2.5% that such structures entail. Just 9% after taking out the fees. Also, this is not risk free for it entails taking on the credit risk of the issuer. There is no liquidity as well so the managers of such structures do not have much of a duration risk to manage – so what for this 2 – 2.5% fee? That fee, really is to justify the enormous amount of finacial acumen and spreadsheet crunching calculations that goes under anything that swishes using guiles like “structured”, “Knock Out”, “Barrier”, “Participation” etc. Investors who put their money behind such ventures must be feeling really hep and smart about themselves. Imagine having protected your capital (ok, not all of it, 97.5% perhaps 🙂 ) and also participating in the run up of NIFTY. Wouldn’t such males love to brag about it to whoever cares to listen – if some female ears patronise their trumpeting, then all the better! I don’t think I’m stretching the issue – do a random survey, I can bet my widgets that the proportion of investing females that pick up this product would be far lesser than the proportion of investing males that do the same.

SEBI made capital protection on such instruments mandatory some time back, so that lends some saving grace for such macho investors. Thankfully, most ticket sizes (i.e. face value of such debentures/notes) are 1 lakh plus so that means that macho men of modest means will not be able to participate here. Which is good, but then there was this CIO of an asset management house making a case for peddling this for an investment level as low as INR 5000! Wow! That makes it a mass market structured kill! That was from an article that was published in early 2008. In fact the more noise about such products more are the chances that we might be nearing really overbought market levels.  The point behind introducing a sexist angle to this barrier is simply to make a strong point in favour of restricting investing to products and asset classes that one understands. I know most of you would agree that there is nothing hep or cool about buying such notes, but I also do know that if some of you did buy it under whatever compomising situations then a part of you would trumpet. Avoid that. The process of amassing wealth through investing is utterly boring and almost emasculated, if I daresay.

The latent desire that such products seek to serve still needs addressing though. You have a section of the HNI/well heeled type of investors who get edgy whenever the benchmarks seem like peaking up and there is an increase in volatility. The psychological weightage that such investors apply to the act of capital preservation becomes higher. Which is again correct. But I kind of disagree in getting blindsided by the hype around these products and only using such notes to achieve that end. 9% return. Investors would be better off buying a high rated bond (of similar maturity)directly. Picking up a balanced mutual fund might require active monitoring of the fund managers’ actions (since a rising market might invoke some managers’ to increase their allocation to equity in a balanced fund making the risk – reward ratio lean towards the risk side). If you must do something whacky, then take a look at the crude payoff diagram of this structure that I have shown above. What base building blocks can be combined to create something similar to this?

An option strategy called the bull call spread, where one buys an at the money call and simltaneously sells an out of money call at a strike that is around the participation rate of the above structure should achieve a similar payoff. The quantity of options should be scaled up depending on the participation rate of the structure. The net premium paid will be one part of your investment. The balance can be put to work by buying a simple fixed income instrument. And you are home – your manliness intact (if that matters to you!). The hitch here could be finding long dated options – most of you would be using common online trading screens of retail brokerages and the max that you’ll get is a quarter’s look forward. This is something I have not explored myself but what I suggest is that next time your banks’ investment planner or relationship manager calls you, instead of finding an excuse and disconnecting ask that person to give you quotes (i.e. premiums) if you were to purchase/sell long dated options of NIFTY. The premiums would be high, no doubt – but I don’t even know how high. So, it’s a line that at least I am waiting to pick up. Will the bank really negotiate hard for me and try to find me a good deal? Will my notional be high enough for anyone to be really interested in? Does my bank have a prop trading arm where they are be a counterparty to my macho designs? I don’t know the answers to any of these questions – but yes, I am interested in long dated index options, if cost effective.