Wealth managers peddle exotic financial products but can they live up to their promise?

There are various types of market-linked debentures, alternate investment funds, bills discounting, partial investing in an under-construction property and so on.

The most popular one currently is the market-linked debenture where the returns generated on the product are based on the movement of a particular index or set of securities, in a specific time period like 18 months to three years. These products supposedly offer principal protection along with gross returns ranging from 15-18% per annum.

Within the alternate investment funds (AIF), there are different types of funds like real-estate funds, which invest in under construction property, or funds, which invest in commercial real estate for the rental yields. There are also AIFs that follow a credit risk strategy; these invest in companies that come with low credit ratings. And then, there are the traditional private equity funds.

Then there is a real estate product where investors can invest partially in an under-construction property. Here an investor can invest Rs 10 lakhs in an apartment and exit after 18 months with a 16-18 percent return. This is literally like giving a short-term loan to the builder.

Bills discounting has been around for a long time but now it is available through platforms, which essentially provide money to borrowers against invoices that they have raised on blue-chip companies. These platforms raise money from individual investors to lend out.

There are many other alternate products, commodity-linked products etc.

Problems with alternative investments

These products are sold on the basis of high gross returns, but the investor return which is post-expenses (including profit share) & post-tax, barely beats regular mutual funds. AIFs typically have a profit sharing of 20 percent of the returns. One the earliest real estate funds ended up giving investor returns similar to a short-term debt fund. There was no point in locking in funds for 6-8 years and having a large part of the return go as profit share with the fund. Investors are inherently biased with real estate and hence do not question the ability of the AIF to get back monies.

The risks in these products are very high and investors are not made aware of the same. With bills discounting there is a risk of default from the company, which was the case last year when Cox & Kings did not honour the invoices. With market-linked debentures, my observation has been that the funds raised are mostly used for the lending business of the firm, which is not known to investors. Essentially, the investor is lending money to the NBFC to lend out further. Most investors wouldn’t do so and hence the MLD structure is brought in.

The biggest issue that is plaguing any market today is liquidity and even if the borrower has good intentions, not being able to sell and generate cash is a problem. In such a situation, how would a MLD or a rental yield fund or a fund that buys under-construction property give back principal to the investor? And it doesn’t look like the liquidity situation is going to get better soon.

Further, there is not enough regulatory oversight and most of these investments are neither rated nor listed. Rating and listing means scrutiny by a third party and certainly some information in public versus the current black box. While rating itself is not enough (as we have seen the issues with rating), it serves as a sanitation check.

Finally allocating large amounts to structured products leads to higher concentration risk for the investor and one default can have a significant impact on the portfolio.

But don't some of the sales pitches claim that investments are secured and provide principle protection?

Over the last two years, with successive defaults like IL&FS, DHFL, Essel etc., the much-touted covenants could not be implemented and legal recourse is long drawn.

The covenants like pari-passu charge on assets, promoters guarantee, pledges shares etc. are taken to protect against delinquencies and to some extent show the borrower’s intentions. However, physical assets have a long unwinding process and promoters guarantee cannot be enforced. Further, priority of the security also matters and banks that are senior lenders would typically have the first right on a security. Investors would be way down in the priority list.

What should investors do?

First, do not fall for pedigree. Even the largest private equity fund in the world is struggling to get back its investments in its lending business in India. Pedigree does not guarantee anything. Investors are in fact scared to even put a class action suit against influential firms. A real estate fund raised in 2006 by an influential real estate investor, close to India’s largest business group has not yet given any return and has neither paid back principal. No one wants to or has the time to take legal recourse against such firms, even though they have taken lousy investment decisions and have lost investors money. So much for their capabilities!

Second, if you have invested in an alternate product, ask for returns calculation. I have seen wealth management firms giving out excel spreadsheets, which have no standing legally. Unless there is an audited report, do not believe in these spreadsheets.

Third, given the heighted liquidity situation, what if you wish to redeem your investment? Relationship managers who peddle you such products or product manufacturers would most likely tell you tales about why this is not such a good time to redeem, markets are down, so let’s wait etc. Investor should read up the exit clause and try to exit at the earliest.

Four, before you invest in these products, evaluate how the fund makes the high promised returns. Recently, I came across an AIF, which invests into warehouses and is providing a net yield of 9.5% pre tax with an expected internal rate of return (IRR; a method to calculate returns consisting of uneven outflows and inflows) of 12-20%. As an investor, do you understand how warehousing works? With the performance-based expenses, what will the 20% gross return actually work out to? Probably 9-10% post tax. Is it worth investing with an unknown firm for an unknown opportunity for a 9% return?

Similarly with market linked debentures, if they are so bullish on Indian stock indices, why not just buy a low-cost index fund instead of concentrating your investment in the non-convertible debenture of an unrated and unlisted non-banking finance corporation? Given all that one is hearing about related third-party transactions, it is not advisable to do so, especially since the funds raised are used to lend to lower category borrowers, who cannot avail loans from banks.

Most structured investments are opaque and have high concentration risk. They have low liquidity, minimal regulatory oversight and the guarantees provided do not work. Finally the post expense, post tax return is not much more than what you can get in a mutual fund. Your best bet is to stay away.

(The writer is a financial educator, money mentor and founder of Finsafe India)