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.

Obama Speak

The US President is going around asking his fellow countrymen to produce more graduates and compete with the likes of India and China. These are good points to raise but then when this is accompanied by curbs on granting visas it begins to sound like rhetoric. All under the guise of protecting US borders! The border security bill will hike visa fees to $2,000 per applicant for companies that have fewer than 50% of its workforce as US citizens. Thats a cool $200 million bill for Indian software companies that rely heavily on “body shopping”. The standard line of the Indian industry has been a lament on the lack of the totalisation pact between the two countries. India has to contribute towards social security for the workers that it sends to the US – and if they return back to India, there is no possibility of a refund. I would welcome to hear something from Dr. Manmohan Singh on the issue. He is his usual quiet self.

While India remains preoccupied with flash floods, Kashmir, honour killings and the Commonwealth Games tamasha, China picked up the gauntlet and responded well by making outsourcing completely tax free if delivered from 21 cities. The Chinese have made no bones about the fact that they want to end India’s dominance in the sector. Should India not make a counter move to steal some foundries away from China?

India’s earlier responses sound quite pathetic to me. If the US politicians are ushering their wards back to school and hoping and helping their middle class to retain their sources of income, whats wrong with it? Cribbing about it and making it sound as if some grave injustice is being done against it is mooching. How would India feel if people across its eastern border arrived in hordes and stole away jobs? Some factions cannot even tolerate intra country movement of labour.

The rhetoric in the US however is also missing its mark. Senator Charles Schumer has called Infosys a chop shop. Its easy for the sound bytes to morph into an India/China hate undercurrent (if one does not exist already). Lou Dobbs, a popular media anchor, for instance has written a book on outsourcing and devotes much of his website to the phenomenon and how the American middle class is being killed. Is it? Don’t think so. Maybe going through a very tough phase. An important counterpoint to note is the indirect benefit that this can yield to the US.

It would be good for the US to note that the Indian middle class is gravitating towards more and more consumerism. People are seeing their incomes rise and are swiping their credit cards, buying second houses, ipods, etc. gleefully. This is allowing banks like BoA, Citibank etc to set up their shops in India. While such benefits selectively accrue to the Dells, Microsofts and BoAs of the world, the American middle class can certainly benefit. President Obama should also consider exhorting his masses to match imports (of services from China and India) with American exports to these countries. The oriental appetite for consuming intelligently designed goods and services in the occident will only grow. Americans would do well to understand one basic trait of most Indian middle classes – they are afraid to take risks. Innovation is rarely seen. While hordes of software junkies pound away at maintenance and basic software jobs, there is hardly any technological breakthroughs that emerge from this populous nation. The US has always thrived by managing risk and employing innovation which have set up a very strong financial acceptance to see capital freely flowing to fund ventures that are risky. Indians generally take the easy way out – outsourcing is one of them.

But these shifts and changes, as significant as they can be, happen slowly and the threat of the current American middle class losing its plot somewhere is indeed very real. And such Obama speak will found many takers and therefore votes. Whether the White House politicians actually act in earnest to plug the leak (which in my opinion they should not blindly do) is a different matter. Donations from many top industry groups may be funding the election expenses of these law makers.

In my opinion, its futile for the US (as a nation and culture) to fight outsourcing. Its perfectly logical and sane for the US society to agitate and therefore equally logical for the politicians to flog this sentiment for election victories. The US should focus on earning export dollars (USD should depreciate as years roll by) by tapping into the growing prosperity in China and India. India and China, on the other hand, should open up their economies further, slicing and selling off non-strategic assets to the highest bidders and generating more wealth in the process. Its a great lifetime to spend in the Indian and Chinese capital markets of today.

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