Portfolio Re-engineering

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Uncertainty is here to stay

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How have the conventional strategies affected portfolios in the recent times?

Returns from debt : 8%

Returns from Equity : 12%

}
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Expected Returns

Debt Fund categorys average CAGR : 7.59%#

Returns in the past three years

Nifty has generated a CAGR : 3.34%*

Large Cap Fund categorys average CAGR : 3.36%*

#Income fund Category Average. *As per ACE MF 16 Dec 2013

What drives portfolio performance?

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Conventional Portfolio Engineering

Time Spent

Investment Decisions

Impact on Returns

10%

Asset Allocation

92%

KEY !!
60-70%

Security Selection

< 5%

20-30%

Market Timing

< 2%

*Brinson, Singer & Beebower

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What are the risks that every investor faces?

If a portfolio is predominantly debt oriented, though volatility is under control, the purchasing power of the corpus reduces with time. On the other hand, a significantly growth oriented portfolio has the potential to cause severe mental stress in the short-term.

Short-Run

Long-Run

Volatility

Inflation

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How do we decide on Asset Allocation?

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The current chaos indicates that one needs to break away from conventional strategies to deal with surprises. Is it really possible to generate alpha despite the circumstances

?
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Yes It is possible to generate alpha

Secured Call (55% Coupon)
IRR 13.54%
Key Terms & Specifications
Tenor Coupon Decay Multiple (DM1) Decay Multiple (DM2) 1,260 days 55% to 56% 5.075 1.80 If Final Fixing level is at or above 80% of Initial Fixing level If the Final Fixing level is at or above 72% and below 80% of Initial Fixing Level If Final Fixing level is below 72% of Initial Fixing Level

Nifty Accelerator (90% Coupon)

IRR 21.22%
Key Terms & Specifications
Tenor Maximum Coupon Participation Rate Contingent Levels 1,217 90% to 92% 900% to 920% 110% If the Final Nifty Level is above the initial level, participation rate of 900% upto first 10% rise in the nifty level after which the coupon is capped at 90%. On the downside there is 1:1 participation i.e. if nifty falls by 1% the principal erodes by 1%.

Payoff

Payoff

73.3% 55.0% 36.7% 18.3% 0.0% -18.3% -36.7% -55.0% -73.3%

Nifty Returns

Product Returns

112.5% 90.0% 67.5% 45.0%

Nifty Returns

Product Returns

Maximum returns when final nifty level is above 80% of Initial Fixing Level

22.5% 0.0%

-22.5%
-45.0% -67.5%

Maximum returns when final nifty level is above 10% of Initial Fixing Level

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Advantages of Including passive strategies using Structured Products

Can be highly customized based on view (range, bullish, bearish or hedge)

Higher Probability of generating alpha on portfolio

No Human Intervention

No Path Dependency

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Having discussed the benefits of passive strategies, lets bust a few myths commonly associated with Structures.

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Myth 1 Structured Product is a Black Box

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It may not be simple, but it is not complex either Let us deconstruct with an example

Protected Call Series VIII - ARG/FY2013/JAN/10

Underlying Tenor Coupon Payoff : Nifty : 1237 days : 61%

Decay Multiple : 1.75 : Max(-100%,Min(Coupon, Coupon + DM * NP))

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Construction

Payoff Table
Final Nifty Levels 3600 3800 4000 4200 4400 4600 4800 5000 5200 5400 5600 5800 6000 6200 6400 6600 6800 7000 7200 7400 7600 7800 8000 8200 8400 8600 8800 9000 9200 9400 9600 9800 10000 Nifty Returns -40.00% -36.67% -33.33% -30.00% -26.67% -23.33% -20.00% -16.67% -13.33% -10.00% -6.67% -3.33% 0.00% 3.33% 6.67% 10.00% 13.33% 16.67% 20.00% 23.33% 26.67% 30.00% 33.33% 36.67% 40.00% 43.33% 46.67% 50.00% 53.33% 56.67% 60.00% 63.33% 66.67% Product Returns -9.00% -3.17% 2.67% 8.50% 14.33% 20.17% 26.00% 31.83% 37.67% 43.50% 49.33% 55.17% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00% 61.00%

Initial investment : Rs. 100 Park the initial investment at 11.25% p.a. Returns after 1237 days: Rs. 144

Earn premium by selling 1.75 PUTS at Rs. 11 Park the premium amount at 11.25% p.a. Return after 1237 days : Rs. 17
Total Inflow at maturity: Rs. 161
Payoff Chart

81.33% 61.00%

40.67%
20.33% 0.00% -20.33% -40.67% -61.00%
Nifty Returns Product Returns

*Assuming initial nifty of 6000

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Product Strategy & Corresponding Payout

Product Strategy
Invest principle amount Rs.100 with treasury @11.25% for 1237 days which will grow to Rs.144

Final Nifty Levels in %

Payout of Step 1

Payout of Step 2

Payout of Step 3

Payout of Net Payout Step 4

-40%
-30% -25% -20%

144
144 144 144 144 144 144 144 144 144 144

-40
-30 -25 -20 -15 -10 -5 0 0 0 0

-30.00
-22.50 -18.75 -15.00 -11.25 -7.50 -3.75 0.00 0.00 0.00 0.00

17
17 17 17 17 17 17 17 17 17 17

91.00
108.50 117.25 126.00 134.75 143.50 152.25 161.00 161.00 161.00 161.00

Step 1

Step 2

Sell Insurance, on Nifty, which provides 100% coverage to Mr. X and earn Rs 6.29 premium Sell Insurance, on Nifty, which provides 75% coverage to Mr. Y and earn Rs 4.71 premium i.e. Total premium earned is Rs.11

-15% -10% -5% 0% 5% 10% 15%

Step 3

Step 4

Invest total premium of Rs.11 with treasury @11.25% for 1237 days which will grow to Rs.17

20%
25%

144
144

0
0

0.00
0.00

17
17

161.00
161.00

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Myth 2 Structured Product is an Alternate Asset Class

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Structured product is not a product, it is a platform or a wrapper like a mutual fund

Structured Product can form a part of the core portfolio based on the underlying features of the product For example, high participation based products can be part of the equity portfolio where as fixed coupon products can be plugged in the debt portion of the portfolio

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Myth - 3 Structured Products Never Make Money

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Actual Performance of Some of the Structured Products

Structure Name Tenure (Months) 36 NIFTY Returns 61.6% SP Return 114% Returns Alpha 52% Coupon Product Features 175% PR product Coupon 8% plus 200% PR product with contingent & KO Coupon 14% plus 150% PR product with contingent & KO

RELIGARE PMS APF (Barclays) Milestone NIFTY Linked SPS LVIII (Macquarie INE796L07258) Milestone NIFTY Linked LXV (Macquarie INE796L07274)

16

19.31%

46.74%

27%

16

18.08%

39.61%

22%

MILESTONE NIFTY LINKED SPS VII (ECL)

Milestone NIFTY Linked SPS L (INE804I07BN8) Religare PMS SPS VI (ECL) MILESTONE GOLD LINKED SPS I (Edelweiss)

24

-1%

18%

19%

18%

18% Fixed coupon with 40% PR and 100% downside PP

Coupon of 22% with downside contingent of 75% 21% auto call coupon 90% PR with 100% downside protection

18

4.56%

22.00%

17%

15

3%

21%

17%

16.50%

24

51.46%

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Myth 4 Structured Products are Very Risky

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The approximate size of Structured Products market in India today is US$ 4 Billion* Not a single default or delay by any issuer till date, since the inception of structured products in India

*Source - http://www.risk.net/structured-products/news/2135331/-net-worth-investors-india-alternative-assets-report
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Myth - 5 Rating is the only criteria

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Issuer Risk Assessment

Perceived Risk Rating generally reflects the perceived risk of the issuer. Rating agencies have set parameters for rating an issuer. While it is an important criteria, it cannot be the only criteria for evaluating the risk.

Actual Risk Actual risk of the issuer can be assessed by considering various aspects: Due diligence on balance sheet Line of business activity Parentage Understand the risk mitigating measures of the options desk

(% of OTC contracts..etc)

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Myth 6 Principal Protection is a must

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100% Principal Protection may not be necessary on all Structure Products Non Principal Protected or Partial Principal protected products can have better Risk Reward payoff
3 Years Nifty Rolling Returns for the past 10 Years

350.00% 300.00% 250.00% 200.00%

Returns (%)

150.00% 100.00% 50.00% 0.00%

Redemption dates
-50.00%

3 Years Rolling Returns of nifty from 2003 to 2013 suggest that, Nifty has never dropped below 20% in any of the 3631 observations.

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Myth 7 Costly Affair & No Exit Mechanism

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Cheaper Investment Option One time 0.5% to 3% fees against 2% management fees annually charged by Mutual Funds. Easy Exit Mechanism Unwind quotes are available almost on daily basis

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Thank You

Disclaimer:-This report has been issued by Anand Rathi Financial Services Limited (ARFSL), which is regulated by SEBI. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments"). ARFSL and its affiliates may trade for their own accounts as market maker / jobber and/or arbitrageur in any securities of this issuer(s) or in related investments, and may be on the opposite side of public orders. ARFSL, its affiliates, directors, officers, and employees may have a long or short position in any securities of this issuer(s) or in related investments. ARFSL or its affiliates may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any entity mentioned in this report. This research report is prepared for private circulation. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Past performance is not necessarily a guide to future performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report.

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