Does higher wealth demand more complex financial products in one’s portfolio?

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One Saturday evening, my long-time friend Joseph got a call from his private banking relationship manager. She wanted to brief him about a new structured product available for subscription. 

Joseph, who is in his 40s, has a rocketing career in marketing and has amassed considerable wealth. But, till now, he had invested in bank FDs and equity mutual funds. His relationship manager wants to showcase a promising offering usually customised for HNIs. 

Enter MLDs

In a usual debenture, interest is paid regularly based on the coupon rate. However, for an MLD, the income stream is linked to a specific market index (Nifty in this case). If the Nifty goes up during the tenure (usually 3-5 years), you earn the returns of Nifty. If it does not, you do not lose your principal. 

So, it is a sort of principal-protected MLD where you are guaranteed to get the principal under the worst circumstances. But, at the same time, returns are linked to market performance. 

At a juncture when interest rates are at an all-time low, it seemed an attractive proposition for conservative investors like Joseph. 

Moreover, the relationship manager highlighted its tax advantage. While interest on a bank fixed deposit is taxed at 30%, gains from MLDs are taxed at just 10%. 

Joseph was on the verge of achieving some of his critical goals and didn’t need to take risks. So, he had a lesser part of his investments into equity-oriented portfolios. But this offering seemed innocuous as there was no downside to investing in it. 

However, he had a good question “What if the equity market doesn’t move much?

Like some retail investors, he felt that the equity market had rallied a bit in the recent past and might not offer a significant upside from these levels. 

That’s when his relationship manager pulled out another investment brochure. This time it was a capital-protected structured product that gave double the returns of Nifty. How is that so?

When an investor gives Rs 100 to buy a structured product, Rs 77 is invested in a debt instrument whose value at the end of the maturity (say three years) becomes Rs 100.

The remaining amount of Rs 23 is invested in a derivative instrument instead of indices. So, instead of investing Rs 23 in Nifty, two options of Nifty (for the same price) are bought that, in turn, allow earning two times the Nifty returns on maturity. 

At the end of the tenure, the debt portion will become Rs 100 (as explained above). And if Nifty goes up by 15% over three years, the call option would reap a benefit of 30%. Thus, the structured product will return 30% over three years. However, if the Nifty falls, the investor gets only Rs 100.

Should investors like Joseph go for complex financial products which are only available for the well-heeled – those investing a minimum of Rs 10 lakh or above?

Here are some factors to consider:

Liquidity

Unlike mutual funds, structured products are not liquid by nature, and therefore you may have to stay put till maturity. Some of the MLDs might provide some intermittent liquidity and no more. While some issuers or merchant bankers assure of buybacks, hardly do they give it in writing. 

Credit risk

Your principal repayment is dependent on the creditworthiness of the issuer. For example, an economic downturn or financial deterioration can lead to a repayment default. So, nothing is guaranteed. 

Cost and pricing transparency

There are upfront commissions to be paid for buying MLDs. If you pay a 2% commission to buy MLD that yields 10%, your eventual returns will come down drastically. Moreover, there is a lack of pricing transparency. Many structured product issuers price their commissions in derivative pricing to avoid an explicit fee for investors. 

Complexity

Investors need to gauge the risk in a complex financial product. There are chances of losing heavily due to leveraging and other derivative strategies. In addition, some strategies come with a cap on the upside that limits your gains. So, check the fine print. 

Takeaway

Investments are best kept simple, even if you have opportunities to customise. Keep in mind that complex financial products often cloud their true risk potential and come with many inherent challenges.

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