portfolio re engineering

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Portfolio Re-engineering


Uncertainty is here to stay …


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

Debt Fund category’s average CAGR : 7.59%#

Nifty has generated a CAGR : 3.34%*

Returns from Equity : 12%

Returns from debt : 8%

Returns in the past three years

Expected Returns}

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

Large Cap Fund category’s average CAGR : 3.36%*


What drives portfolio performance?


Conventional Portfolio Engineering

*Brinson, Singer & Beebower

Asset Allocation

Security Selection

Investment DecisionsTime Spent

10%

60-70%

20-30%

Impact on Returns

92%

< 5%

< 2%

KEY !!

Market Timing


What are the risks that every investor faces?

Short-Run Long-Run

Volatility Inflation

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.


How do we decide on Asset Allocation?


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

?


Key Terms & Specifications

-73.3%

-55.0%

-36.7%

-18.3%

0.0%

18.3%

36.7%

55.0%

73.3%Nifty Returns Product Returns

Maximum returns when final nifty level is above

80% of Initial Fixing Level

Secured Call (55% Coupon)

Tenor 1,260 daysCoupon 55% to 56%Decay Multiple (DM1) 5.075 Decay Multiple (DM2) 1.80

Payoff

If Final Fixing level is at or above 80% of Initial Fixing levelIf 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

-67.5%

-45.0%

-22.5%

0.0%

22.5%

45.0%

67.5%

90.0%

112.5%Nifty Returns Product Returns

Maximum returns when final nifty level is above

10% of Initial Fixing Level

Tenor 1,217

Maximum Coupon 90% to 92%

Participation Rate 900% to 920%

Contingent Levels 110%

Payoff

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%.

Key Terms & Specifications

Nifty Accelerator (90% Coupon)

IRR 13.54% IRR 21.22%

Yes … It is possible to generate alpha


Advantages of Including passive strategies using Structured Products

No Path Dependency

No Human Intervention

Higher Probability of generating alpha on portfolio

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


Having discussed the benefits of passive

strategies, let’s bust a few myths commonly

associated with Structures.


Myth – 1

Structured Product is a ‘Black Box’


• 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 : Nifty

• Tenor : 1237 days

• Coupon : 61%

• Decay Multiple : 1.75

• Payoff : Max(-100%,Min(Coupon, Coupon + DM * NP))


Payoff Chart

-61.00%

-40.67%

-20.33%

0.00%

20.33%

40.67%

61.00%

81.33%

Nifty Returns Product Returns

Payoff Table

Final Nifty Levels Nifty Returns Product Returns

3600 -40.00% -9.00%

3800 -36.67% -3.17%

4000 -33.33% 2.67%

4200 -30.00% 8.50%

4400 -26.67% 14.33%

4600 -23.33% 20.17%

4800 -20.00% 26.00%

5000 -16.67% 31.83%

5200 -13.33% 37.67%

5400 -10.00% 43.50%

5600 -6.67% 49.33%

5800 -3.33% 55.17%

6000 0.00% 61.00%

6200 3.33% 61.00%

6400 6.67% 61.00%

6600 10.00% 61.00%

6800 13.33% 61.00%

7000 16.67% 61.00%

7200 20.00% 61.00%

7400 23.33% 61.00%

7600 26.67% 61.00%

7800 30.00% 61.00%

8000 33.33% 61.00%

8200 36.67% 61.00%

8400 40.00% 61.00%

8600 43.33% 61.00%

8800 46.67% 61.00%

9000 50.00% 61.00%

9200 53.33% 61.00%

9400 56.67% 61.00%

9600 60.00% 61.00%

9800 63.33% 61.00%

10000 66.67% 61.00%

*Assuming initial nifty of 6000

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

• Earn premium by selling 1.75 PUTS at Rs. 11Park the premium amount at 11.25% p.a.Return after 1237 days : Rs. 17

• Total Inflow at maturity: Rs. 161

Construction


Product Strategy & Corresponding Payout

Final Nifty Levels in %

Payout of Step 1

Payout of Step 2

Payout of Step 3

Payout of Step 4

Net Payout

-40% 144 -40 -30.00 17 91.00

-30% 144 -30 -22.50 17 108.50

-25% 144 -25 -18.75 17 117.25

-20% 144 -20 -15.00 17 126.00

-15% 144 -15 -11.25 17 134.75

-10% 144 -10 -7.50 17 143.50

-5% 144 -5 -3.75 17 152.25

0% 144 0 0.00 17 161.00

5% 144 0 0.00 17 161.00

10% 144 0 0.00 17 161.00

15% 144 0 0.00 17 161.00

20% 144 0 0.00 17 161.00

25% 144 0 0.00 17 161.00

Product Strategy

Step 1

Invest principle amount Rs.100

with treasury @11.25% for 1237

days which will grow to Rs.144

Step 2

Sell Insurance, on Nifty, which

provides 100% coverage to Mr. X

and earn Rs 6.29 premium

Step 3

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

Step 4

Invest total premium of Rs.11 with

treasury @11.25% for 1237 days

which will grow to Rs.17


Myth – 2

Structured Product is an ‘Alternate Asset Class’


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

• Structured Product can form a part of the core portfolio based on theunderlying features of the product

• For example, high participation based products can be part of theequity portfolio where as fixed coupon products can be plugged in thedebt portion of the portfolio


Myth - 3

Structured Products ‘Never Make Money’


Structure NameTenure

(Months)NIFTY

ReturnsSP

ReturnReturns Alpha

CouponProduct Features

RELIGARE PMS APF (Barclays) 36 61.6% 114% 52% – 175% PR product

Milestone NIFTY Linked SPS LVIII (Macquarie INE796L07258)

16 19.31% 46.74% 27% –Coupon 8% plus 200% PR

product with contingent & KO

Milestone NIFTY Linked LXV(Macquarie INE796L07274)

16 18.08% 39.61% 22% –Coupon 14% plus 150% PR

product with contingent & KO

MILESTONE NIFTY LINKED SPS VII (ECL)

24 -1% 18% 19% 18%18% Fixed coupon with 40% PR

and 100% downside PP

Milestone NIFTY Linked SPS L (INE804I07BN8)

18 4.56% 22.00% 17% –Coupon of 22% with downside

contingent of 75%

Religare PMS SPS VI (ECL) 15 3% 21% 17% 16.50% 21% auto call coupon

MILESTONE GOLD LINKED SPS I (Edelweiss)

24–

51.46%– – 90% PR with 100% downside

protection

Actual Performance of Some of the Structured Products


Myth – 4

Structured Products are ‘Very Risky’


• The approximate size of Structured Products market in India today isUS$ 4 Billion*

• Not a single default or delay by any issuer till date, since the inceptionof structured products in India

*Source - http://www.risk.net/structured-products/news/2135331/-net-worth-investors-india-alternative-assets-report


Myth - 5

‘Rating’ is the only criteria

.


Perceived Risk Actual 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 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).

Issuer Risk Assessment


Myth – 6

‘Principal Protection’ is a must


• 100% Principal Protection may not be necessary on all Structure Products

• Non Principal Protected or Partial Principal protected products can havebetter Risk Reward payoff

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

-50.00%

0.00%

50.00%

100.00%

150.00%

200.00%

250.00%

300.00%

350.00%3 Years Nifty Rolling Returns for the past 10 Years

Redemption dates

Re

turn

s (

%)


Myth – 7

‘Costly Affair’ & ‘No Exit Mechanism’


Cheaper Investment Option

• One time 0.5% to 3% fees against 2% management fees annuallycharged by Mutual Funds.

Easy Exit Mechanism

• Unwind quotes are available almost on daily basis


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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