Ride the market volatility and protect capital too

Stock markets have been edgy ahead of packed political action over the next 12 months. Then, there is the troika of creeping up inflation, oil on the boil and global trade wars. In this backdrop of volatile equity markets, smart and sophisticated investors are looking at strategies that can protect their capital. Because losing less is winning more. DNA Money spoke to experts on investments that can be a fit: structured products, fixed maturity plans, and capital protection oriented schemes. Read on.

Structured products

Traditionally, a structured product, also known as market-linked debentures (MLDs), are a packaged combination of debt plus options in the form of Non-Convertible Debentures. Coupons of these MLDs were linked to underlying Indices.

Many players are generating alternative credit products through their non-bank finance company and alternative investment funds platforms. Vikrant Narang, MD and head of structured finance, Ambit Finvest said: “Affluent investors get exposure to high-quality unlisted companies in non-traditional situations such stake consolidations by promoters, private equity exits, liquidity mismatches in operating companies among others." The risk is higher versus plain vanilla lending in such higher yielding investments. However, the manager strives to create a strong downside protection by collateral pools as a combination of assets inside the operating companies and/ or by accessing promoter controlled assets, added Narang.

With the advent of active portfolio management, more and more investors started opting for such actively managed portfolios, said Roopali Prabhu, head of investment products, Sanctum Wealth Management. To attract such investors, a new strategy has emerged in the structured product industry that combines equity expertise from larger AMCs and structuring capabilities of Issuers. "This combination adds up benefits of active management and structuring capabilities to offer superior returns. The strategy offers 100% upside on the actively managed index with full principal protection in case of a downturn," Prabhu explained.

An assessment of the issuer risk is a key decision factor before investing in a structured product or market-linked debenture. Investors need to check the credit ratings (preferably rated the same by two rating agencies) and also understand the risks/ conditions of investing in the structured product, advised Umang Papneja, senior managing partner, IIFL Investment Managers.

Over the last few months, a lot of investors have started enquiring and in turn investing in structures linked to single stocks or a basket of stocks. "This strategy allows investors to participate on the upside of the stock (in most cases at 100%) in a bull run and protect the downside in a bear run as these products are 100% capital protected," said Prabhu.

A structured product can have pay-off closer to fixed income. Because of the variability of the coupon, these instrument if sold prior to maturity, but after holding for 12 months, can be taxed at 10%. If one compares this to a bank FD (interest tax up to 30%), investors can potentially make a much higher post-tax return. Even where the pay-offs are closer to equities, the taxation could be similar.

Capital protection oriented schemes

Another popular product is from mutual funds' stable - Capital Protection Oriented Schemes (CPOS). These are essentially close-ended hybrid schemes which invest the majority of the corpus (typically about 80%) in debt and money market instruments, and the rest in equity and equity related instruments. While debt component ensures steady returns and principal protection, equity component enhances their scope of capital appreciation. Manish Kothari, director & head of MF, Paisabazaar.com said: "As CPOS invest bulk of their corpus in debt instruments to reduce downside risk, their upside potential is much lower than equity-oriented mutual funds. Hence, only those investors having low-risk appetite and seeking consistent returns without risking their principal amount should opt for these funds."

Being non-equity funds, capital gains booked within three years of investment are treated as short-term capital gains and taxed as per the tax slab of investors. The gains booked after three years of investment are treated as long-term capital gains and are taxed at 20% with indexation. Given that almost all CPOS are close-ended for at least three years, the gains booked by investors will be treated as long-term capital gains and taxed accordingly, said Kothari.

CPOS are ideal for investors with low-risk appetite who wish to benefit from equity investments without risking their principal amount. These schemes are also more tax-efficient than fixed deposits for investors falling under 20% and 30% tax slabs.

Fixed Maturity Plans

Known as FMPs, these products are similar to FDs in that they mature after a fixed period and the instruments in them are held to maturity. In a nutshell, FMPs are close to FDs in their return profile. In good times, some FMPs returns have given 10-14% annual returns, but there is no guarantee. The biggest advantage of FMPs is that you hold a basket of debt instruments and the capital gains indexation for holding beyond three years makes them far more tax efficient compared with FDs.

"Theoretically, since FMPs lock into instruments and hold them till maturity, it should not just protect capital but provide the interest rate of the underlying instruments. However, if the companies of underlying instruments default, there is a risk to capital," said Vidya Bala, head of MF research, FundsIndia. She gives the example of 2008 when the risk of default of underlying instruments led to FMPs had to be rolled over to wait for the payments. Hence, there is no 100% certainty. However, the risk is significantly reduced if the FMPs go with high-rated instruments.

To be honest, the structure of FMPs is not to capture capital appreciation opportunities. Actually, it is to benefit from the coupon of a wide range of instruments by buying and holding them. "This structure is not meant at capping upside nor protecting downside. It is simply to provide a product that is closer to FDs in terms of buy and hold and get returns of the underlying instruments with reasonable certainty," advised Bala.