In the last few years, some HNI investors are embracing complex financial instruments, ignoring the risks. These include structured notes, sector-focussed thematic PMS schemes, AIFs (alternative investment funds), long short funds or even long tenored funds investing into seed and venture stage unlisted companies.

Beyond the usual risks of going for equity, those investing in exotic instruments need to factor in illiquidity, opaque NAVs, potential tax liabilities and higher exit costs.

Investors are usually shown the sky, highlighting mainly the upside and not the risks or limitations. Unfortunately, investors seem to be ignoring these risks altogether.

Complex financial investments have risks that cannot be easily understood.

While there have been numerous failures in such financially engineered products, since they are not in public domain, information is not easily available.

Alternate asset investments

We now have alternate funds in healthcare, technology, Internet and e-commerce, media, agriculture, seed stage, early stage, late stage and biotech. Most of these are in emerging sectors, with limited history.

While category I AIF caters to angel funds, SME, infrastructure and social venture funds, category III AIFs employ complex and diverse trading strategies. The latter typically have high fee structures, limited track record and returns that are fully taxed at marginal rate.

Moreover, during the life cycle of the investment, investors have to contend with infrequent updates and opaque valuations.

Internationally, alternate asset investments are fairly popular and evolved.

However, in India, most of the investors are stuck with illiquidity and sub-optimal returns. Ironically, for all the jazz, even if the fund delivers, high fees, carry (costs) and taxation will easily take away a third to half of gross returns.

Portfolio management

While PMS is not a new concept, investors have been warming up to it, thanks to significant appreciation of stock prices of many small and mid cap companies.

Similar to AIFs, PMS tend to have high fees, profit sharing and steep exit loads. In case of any under-performance, while investors may have a choice to exit, albeit at a steep cost.

Structured notes

Structured notes are complex financial instruments with embedded derivatives.

Valuing such securities is therefore extremely complicated and most investors have little understanding on how to evaluate them.

Structured notes, usually backed by collateral, are of two types — capital protected or non-capital protected.

For unprotected structures, the taxation on gains is at the maximum rate. In most issuances, high fees are levied .

While this space was earlier dominated by foreign banks, we have seen a few large domestic NBFCs becoming active in this segment.

Issuer rating and strength of the issuer’s balance sheet are critical, as investments are subject to credit risk.

There are instances wherein an aggressive domestic NBFC has issued unrated structured notes to investors by leveraging their existing investments.

In this instance, investors run three risks — underlying investment risk, credit risk on unrated paper and leverage risk. All in all, a recipe for disaster.

The more complicated the product, the less known are the risks and, therefore, more investment knowledge and experience is required.

It takes years of experience and technical expertise to understand complex financial instruments and are, hence, best suited for professional investors. There is simply no need to add additional risks for no increment returns.

In complex investment products, reading the fine-print is a must.

Understanding the features, upsides and downsides, risks, fees and commissions and liquidity is important before making any commitment.

Transparent, easy to invest

Importantly, be it alternate assets or PMS offerings, most funds do not have a track record of performing beyond even one market cycle.

On the other hand, there are plenty of high quality equity mutual funds with more than 10-year track record and managed by seasoned professionals.

These are transparent, easy to invest or divest with daily NAVs; portfolios are made available monthly, with reasonable fees and clean tax structure.

Buying simple investment products tends to be far efficient on a risk adjusted basis compared to buying complex securities.

The most optimal way to participate in India’s growth story would be to consider a combination of open-ended equity mutual funds and direct stock holdings.

The writer is Co-Founder and Director of Entrust Family Office Investment Advisors

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