Wednesday, August 20

Structured Products

Gone are the days when the investors had the option of investing only in Equity markets, and if there was any diversification needed, they had the option of Debt, Bullion, Commodities and at the very best, Real Estate. But we all have known the constraints of investing in them. High investment, low liquidity in the markets and long term lock in periods. Then came Mutual Funds which are still considered amongst the best options for investors.

Let me talk about "Structured Products", the secret of how the investment managers (Yes, of Mutual Funds also) manage to generate high returns or at least, maintain the returns.
Investment managers across the globe continuously strive towards designing products that suit various investor requirements. Asset managers in the developed markets (now penetrating in emerging markets like India and China) have been offering structured products across asset classes like equities, debt, forex and commodities for a long time now. However, in India, the pace of growth of these products have been slow due regulatory constraints and awareness/acceptance amongst the investors.

What are structured products?
A structured product is generally a pre-packaged investment strategy which is based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuances and/or foreign currencies, and to a lesser extent, swaps. The variety of products just described is demonstrative of the fact that there is no single, uniform definition of a structured product. A feature of some structured products is a "principal guarantee" function which offers protection of principal if held to maturity. For example, an investor invests 100 dollars, the issuer simply invests in a risk free bond which has sufficient interest to grow to 100 after the 5 year period. This bond might cost 80 dollars today and after 5 years it will grow to 100 dollars. With the leftover funds the issuer purchases the options and swaps needed to perform whatever the investment strategy is. Theoretically an investor can just do this themselves, but the costs and transaction volume requirements of many options and swaps are beyond many individual investors.
As such, structured products were created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. Structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio, or to utilize the current market trend.

An example
The CPPI/DPI (Constant Proportion Portfolio Insurance / Dynamic Portfolio Insurance) type of structured product.
In this type of a structure, initially a fixed portion of proceeds could be invested in underlying equity-based instruments. In the event of weak returns, the manager who is actively managing the structure, pulls some portion of that capital from equities and assigns it to a zero coupon bond whose function is to deliver the investor his principal at maturity. the investment is structured so there is usually enough capital to afford buying the guarantee (the zero coupon bond) throughout the life of the investment, thus assuring a return of capital.

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