Do hybrid fixed-term funds work for you?

Do hybrid fixed-term funds work for you?

Guarantees and capital protection are buzz words for financial product manufacturers in these volatile times—be it life insurance, real estate or mutual funds. These words attract customers, who are otherwise wary because of the prevailing uncertainty.

In the past two-three years, some fund houses have come up with a new product, which aims at preserving the capital, while giving an equity kicker, depending on Nifty’s movement. These funds, which can be categorized as hybrid fixed-term funds, work like capital protection-oriented funds, where a majority of assets under management (AUM) are parked in fixed-income securities for preserving capital and the rest is deployed in equity-linked options to give that additional return.

Since 2010, many such three-year closed-end funds have been launched. At least 8-10 such schemes have been launched this year and three more are open for subscription now. But does it make sense for you to use these funds or should you do your own asset allocation?

What lies in it for you?

How does it work? You will get a fund which invests 80% in fixed income and 20% in equity-linked securities such as call options. This is really similar to your monthly income plan. The difference lies in the fact that this is a three-year closed-end scheme and the equity portion is typically invested in Nifty-linked options, which adds a layer of complexity.

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Although similar in structure, these are not the same as capital-protection oriented schemes, which have tighter regulations, such as maintaining a AAA-rated fixed income portfolio and restriction on exposure to non-banking financial companies (NBFCs). Fund managers prefer these funds as they are more flexible in portfolio construction.

Returns: There are two basic scenarios that can play out. If the Nifty goes up in the three-year period, you stand to make returns more or less equal to the Nifty return (90-100% participation is achieved through call options). If, on the other hand, Nifty were to decline in that tenor, the fund aims at protecting your capital (see graph). Says Kumaresh Ramakrishnan, head (fixed income), Deutsche Asset Management (India) Ltd, “The part invested in fixed income takes care of the expenses (including those linked to buying Nifty options) and the aimed capital preservation at the end of the tenor."

Returns are calculated only at the end of the tenor. Hence, for you, it doesn’t matter how the Nifty moves between the start and the end date. Additionally, the funds get listed on an exchange and investors can exit or trade among themselves, although traditionally volumes are very low. At the end of the tenor, the fund will be all cash (fixed-income securities and options would have matured), which will be then paid back to you in proportion of the units you hold.

Investment size: Last year, the Securities and Exchange Board of India (Sebi) had notified that for investing in similar structured products (which tend to be more customized) issued by NBFCs, the minimum ticket size needs to be 10 lakh, hence access was limited. Now through the mutual fund route you can invest as little as 5,000 in a structured scheme.

What are the risks?

Credit risk: The bulk of the money is invested in fixed income securities, mostly corporate bonds maturing in line with the tenor. The primary risk in this product is credit risk or the risk that the issuers for these fixed income securities may default. The fund manager can invest in AA, AA+, AAA or any other securities across the rating scale (AAA being the best rating, next comes AA, then A and so on). So you need to analyse the portfolio and see that a bulk of it is in AAA or equivalent securities where the risk of default is negligible. Says Ramakrishnan, “The securities in the fixed income part will undergo the same credit appraisal process as the rest of the fixed income schemes we manage."

Market risk: If the fund manager’s view on the upside potential for Nifty in three years does not work out and at the end of the period, the Nifty declines, you risk not gaining anything from this product even after being invested for three years or more. Ideally, the fixed income portion in the meantime would have delivered returns enough to give your capital back, though this is not assured.

Which part of the asset allocation do they fall under?

Don’t make the mistake of looking at these funds as part of your equity allocation, they form a part of fixed income. Says Rajesh Iyer, head (products and research), Kotak Wealth Management, “The call investors need to take is in comparing three-year fixed income (fund) returns vis-a-vis this product and see if this has the potential to return more."

Remember the pay-off from options is not certain. The risk is like a fixed income product (credit risk is the biggest concern) with the endeavour to preserve capital. Hence, the return expectation from these products needs to be somewhere between fixed income and equity returns. Iyer recommends investing 10-20% of your overall fixed income allocation in such products. Don’t make the mistake of checking your net asset value (NAV) everyday or even regularly as the returns matter only at the end of the tenor.

Should you buy?

Needless to say, given the many ifs and buts in the structure, it is a product meant for high networth individuals (HNI), who can clearly understand option pay-offs and have a specific view on market direction. But it seems HNIs have better options. Says Iyer, “HNIs have access to customised structured products and can build their own structures by investing in fixed maturity plans or bond funds and buying options directly; this is a good product for retail investors who don’t manage asset allocation actively."

Moreover, for HNIs customizing their asset allocation works out cheaper. Says Prateek Pant, head (wealth solutions), Royal Bank of Scotland NV, “These are good products but we found it works out (to be) more expensive for HNIs to invest in these as compared with doing the asset allocation to fixed income and options directly."

But Gaurav Mashruwala, a Mumbai-based financial planner cautions against these funds for retail investors too. He says, “If you seek capital preservation, a better choice is a monthly income plan or fixed deposits and invest the equity portion in exchange-traded funds. Your expenses if you do this will be much lower and if you think Nifty has an upside you will be able to capture it."

If you are an equity investor who understands options, but are unsure about markets and don’t want to take the risk of earning negative returns, this product may work for you. But remember capital is not guaranteed and timing is critical as you have to take a forward view on equity markets. Otherwise you are better off investing in 100% fixed income portfolio.

If all this sounds too complicated, stay away.

Graphic by Yogesh Kumar/Mint.