A Guide To Investing In India's Structured Products

Structured products are hybrid investment instruments that combine multiple asset classes, such as stocks, bonds, and derivatives, to meet the specific needs and risk appetite of an investor. They have been available in India since 2007-08 and are typically offered by private banks, wealth management firms, and non-banking financial companies (NBFCs). These investment products are designed to provide capital protection, flexibility, and diversification to an investor's portfolio, making them an attractive option for those seeking low-risk investments with good returns. In this article, we will delve into the intricacies of structured products, exploring their components, features, benefits, and types, providing a comprehensive guide for investors interested in this complex but exciting investment avenue in India.

Conservative vs. aggressive structured products

Conservative and aggressive structured products are at opposite ends of the investment spectrum. They are designed to meet the needs of different types of investors, depending on their risk appetite and investment goals.

Conservative Structured Products

Conservative structured products are designed for investors who are risk-averse and seek capital protection. These products offer a lower upside participation, meaning that if the index increases by a certain percentage, the investor will receive a proportionally lower return. For example, if the index increases by 10%, an investor with a conservative structured product might only receive a 12% return. The main advantage of these products is that they guarantee the return of the initial invested amount, even if the underlying equities do not perform well. This type of product is suitable for investors who want to preserve their capital and minimise risk, while still generating some returns.

Aggressive Structured Products

Aggressive structured products, on the other hand, do not offer capital protection and have a higher risk of loss. These products provide investors with the opportunity for enhanced returns, but there is also a higher potential for bigger losses. They are designed for investors who are willing to take on more risk in exchange for the potential of higher returns. In the case of aggressive structured products, if the market falls, the investor may lose their capital. The returns on these products are dependent on the performance of the index or underlying assets.

Key Differences

The main difference between conservative and aggressive structured products lies in the level of risk and potential returns. Conservative structured products offer lower upside participation but provide capital protection, while aggressive structured products offer higher potential returns but do not guarantee the return of the initial investment.

Another difference is in the composition of the products. Conservative structured products allocate a larger portion of their assets towards bonds or debts, resulting in lower returns from equities. Aggressive structured products, on the other hand, invest more heavily in equities and derivatives, which are riskier but offer the potential for higher returns.

Additionally, conservative structured products are managed with a focus on preserving capital and minimising risk, while aggressive structured products are designed to maximise returns.

The choice between conservative and aggressive structured products depends on your investment goals, risk tolerance, and time horizon. If you are a conservative investor who prioritises capital preservation and stable returns, a conservative structured product may be more suitable. On the other hand, if you are willing to take on more risk and are seeking higher potential returns, an aggressive structured product could be a better option. It is important to carefully consider your financial situation and objectives before investing in any structured product.

How structured products work

Structured products are pre-packaged investments that combine traditional securities with non-traditional payoffs. They are designed to meet the specific needs of an investor, offering a high level of customisation.

Structured products are made up of three essential components: bonds, equities, and derivatives. The bond component provides capital preservation, the equity component enhances investment, and the derivative component balances the overall risks involved.

In India, structured products typically have a minimum investment value of 10 lakhs. They are usually long-term investments, requiring a lock-in of at least 12 months and an investment horizon of 2-3 years to gain maximum returns. The returns from structured products are linked to the performance of underlying assets, such as the NIFTY index in India.

Suppose you invest 100 INR in a structured product with a three-year investment horizon and capital protection. Out of the 100 INR, 77 INR is invested in a debt instrument that matures to 100 INR at the end of the three years. The remaining 23 INR is invested in a call option on the NIFTY index. If the NIFTY generates a 20% return over three years, the total return on the maturity of the structured product is 140 INR. However, if the NIFTY falls below the initial investment level, the derivative component loses value, and you get back only your initial investment of 100 INR due to the capital protection clause.

Structured products offer investors the ability to customise their investment portfolios and meet their unique financial goals. They provide a combination of secure and volatile investments, allowing investors to reduce their risk levels while maximising returns.

Components of structured products

Structured products are hybrid investment instruments that combine two or more asset classes, such as conventional asset classes like stocks and bonds, with derivative products like forwards, futures, etc. They are designed to meet an investor's specific goals and risk appetite. Here are the components of structured products:

• Bonds: The bond component provides capital preservation as the issuer promises to return the capital, thus offering a source of income and stability. It is a secure investment option that ensures you recoup your entire capital investment amount.
• Equities: Equities enhance investment returns. There is usually one equity or a set of stocks and selected ETFs that follow a particular index, currency, or other underlying assets.
• Derivatives: Derivatives balance the overall risks involved and are related to the investor's risk tolerance. Examples include futures, forwards, swaps, etc. They are investment instruments whose value is determined by the values of the underlying assets. Derivatives help customise the returns from the underlying assets to meet the unique requirements of the investors.

Benefits of structured products

Structured products are hybrid investment instruments that combine traditional and non-traditional assets to improve returns while reducing risk. They are highly customizable and can be tailored to meet an investor's unique needs and goals. Here are some benefits of structured products:

Capital Protection

Structured products can offer capital protection, meaning investors will get their initial investment returned even if the underlying assets do not perform well. This feature provides peace of mind and is especially attractive to risk-averse investors.

Potential for Great Returns

Structured products have the potential to deliver attractive returns by following the performance of an index or a basket of securities. The combination of assets, such as equities, bonds, and derivatives, can generate stable to high returns.

Flexibility and Customization

Structured products are highly flexible and customizable. Investors can choose a product that aligns with their risk tolerance and financial goals, whether they are conservative or aggressive in their investment approach. The ability to customize the product allows investors to benefit from their market views and predictions.

Efficient Taxation

Structured products have favourable taxation features, making them appealing to high net-worth and institutional investors. In India, if the returns are held for more than 36 months, a long-term capital gain tax of 10% is levied. However, due to the complexity of these products, it is recommended to consult a tax expert before investing.

Diversification

Structured products offer a good mix of asset classes, including traditional and non-traditional instruments, providing appropriate diversification to an investment portfolio. The combination of volatile and secure investments helps balance the overall risk.

Professional Management

Structured products are typically handled by experienced fund managers or investment portfolio managers. Their expertise helps to minimize risks and ensure that the investor's goals are met, even during unfavourable market conditions.

Risks of structured products

Structured products are financial instruments that combine volatile and secure investments. While they can be a good way to reduce risk levels, there are several risks associated with them. Here are some of the key risks of investing in structured products in India:

Lack of Liquidity

Structured products tend to lack liquidity due to their highly customised nature. The full extent of returns from complex performance features is often not realised until maturity. As a result, structured products are typically buy-and-hold investments rather than short-term trades. This lack of liquidity means that investors may not be able to exit their positions quickly and efficiently if needed.

Credit Risk

Structured products are considered liabilities of the issuing financial institution. If the issuer encounters liquidity problems or goes bankrupt, investors may lose their initial investments. It is important to assess the credit quality of the issuer before investing.

Lack of Insurance

Structured products may not be insured by the Federal Deposit Insurance Corporation (FDIC) or similar entities. This means that investors could lose their principal investment if the product performs poorly or if the issuer faces financial difficulties.

Complexity

Structured products can be complex and difficult for lay investors to understand. The pricing mechanisms and derivative securities involved in structured products may be hard to grasp for those without a strong financial background. It is important for investors to fully understand the risks and features of structured products before investing.

Pricing Transparency

There is a lack of uniform pricing standards for structured products, making it challenging to compare the attractiveness of different offerings. The true value of implicit costs may be difficult for investors to ascertain.

Market Risk

While structured products can help reduce risk, they do not eliminate it entirely. The performance of structured products is still tied to the underlying assets, and negative market movements can impact their returns. Investors need to be aware of the potential for losses, especially with aggressive structured products that do not offer capital protection.

Frequently asked questions