Are structured products needed?

The turmoil in financial market in recent times has made investors question the justification for long-term investing as their burgeoning profits were wiped out in these unexpected market gyrations. Also, many investors discovered to their unfortunate surprise that their portfolios were not nearly as protected from downside risk and their traditional notion of ‘diversification' failed their expectations. So, are we willing to stick to traditional investments only which move in tandem with the general market or should we actively deploy alternative assets such as Structured Products whose uniqueness provides the right mix of return vs risk.

How do structured products work?

To understand how a Structured Product works, consider an investor investing Rs 100 in a Structured Product (let us assume it has a maturity of three years). Considering a 3-year corporate bond of highest rating gives 10 per cent, approximately Rs 70 would be allocated to a zero coupon bond and remaining Rs 30 can be allocated to equity through options so as to give maximum participation.

A ten per cent interest rate on the debt component of Rs 70 would mature to Rs 100 approximately in three years which ensures that the principal remains intact. On the other hand, let us assume Rs 30 allocated to equity gets doubled in three years, i.e., investors get Rs 160 after a gap of three years, i.e., an approximate simple annualised return of 20 per cent on the portfolio.

Even in the worst case scenario, if the Nifty goes down from the initial value, investors' principal is protected. This is an example of a plain vanilla Structured Product.

Pointers for investors

The three most important components of a structured product are the underlying asset, the issuing entity and its maturity. A structured product focuses on capital protection which happens on the sacrifice of certain market upside. Credit quality is an important aspect, but an investor may prefer slightly less attractive headline terms in order to achieve better returns. It is also useful to compare one product against another before making a decision on what product is best suited to the investor.

Portfolio allocation

Alternative investments can increase diversification and reduce volatility, given low correlations to traditional investments. They can offer the potential for enhanced returns and can hedge certain portfolio exposures, thereby reducing concentration risk.

Even in a sample Markowitz efficient frontier, the inclusion of alternate assets such as structured products can move the efficient frontier up and to the left. So, for a given level of return, risk is lower or for a given level of risk, return is higher. Also, alternate assets may have higher volatility than their traditional investments.

They typically have low correlations to more traditional asset classes and their inclusion in a portfolio tends to result in a lower overall volatility.

Generally allocating 10-20 per cent of a portfolio to alternative investments is the most appropriate way out of which 5-10 per cent can be allocated to structured products.

In India, structured products are still in nascent phase and are widely constructed on Nifty index including some commodities such as gold and silver futures. These products are, however, slowly making inroads in to investor portfolios.

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