Asset management firms’ offer fixed maturity plans within the fixed income space. One of the participants in a workshop that we conducted recently raised an interesting question: Why not have such plans in the equity space as well?
This article discusses the need for equity exposure within a fixed maturity plan and the difficulty in structuring such plans. The problem arises because equity, unlike fixed-income securities, does not have finite life. This non-finite life exposes the portfolio to market risk at the horizon (when the investor wants to encash his investment). Portfolio managers have to apply sophisticated models to manage this risk.
Horizon-matching liability structures
Suppose an investor wants Rs 25 lakh five years hence to fund her child’s education. She can construct a typical portfolio with stocks and bonds. Such a portfolio, if not custom-tailored to meet the investment objectives, will be exposed to market risk at the horizon. This is because the portfolio has to be liquidated five years hence at the market price prevailing then. And if asset prices are down at the horizon, the portfolio may be unable to meet the education cost.
Fixed maturity plans help in this regard. Suppose the investor has lump-sum amount that she wants to invest now to meet this liability structure. She can invest in a five-year fixed-maturity bond fund. The bond fund will only invest in five-year bonds. At the end of five years, the fund will redeem the bonds with issuer-companies and deliver the proceeds to the investors. As the fund is not required to liquidate the portfolio at the market price, it is not exposed to market risk. This helps the portfolio meet the liability structure.
But what if the investor does not have lump-sum amount to invest now? She may invest a smaller sum now and hope to earn higher returns through the five-year period. Or she may invest some amount every year to achieve her investment objective. Typically, the investor will choose to do both.
Fixed maturity plans: Equity exposure?
Investors typically prefer equity exposure because of the higher returns. But investing in equity exposes the portfolio to market risk. This is because equity, unlike fixed income securities, does not have finite life and, hence, cannot be typically redeemed with issuer-companies. That is why asset management firms do not provide equity exposure within the fixed maturity plans.
The question is: Can portfolio managers minimise market risk so as to provide such exposure? One alternative would be to apply asset allocation strategies. This refers to cutting equity exposure and moving into bonds so as to change the portfolio composition.
This process can begin six months before the horizon date. It will help portfolio managers capture profits in the equity portfolio. The flip side is the high cost of cash drag- the cost of earning lower returns because of moving out of equity and losing further upside gains till the horizon date. The portfolio may also suffer impact cost from selling shares. Asset management firms can, however, apply algorithmic trading to optimize trade size and market timing.
Another alternative would be to delta-hedge the equity portfolio with short-term options. This way, the portfolio will participate in upside gains while the put options will protect the downside risk. The hedge cost is the put premium. Astute managers will prefer using a ‘fence’ to reduce the hedge cost. A fence refers to buying a put and selling a higher strike call to minimize the hedge cost.
The objective of this article is not to provide alternatives to reducing market risk at the horizon. Rather, it is to show that such solutions do exist.
What next?
Imagine then a scenario where the asset management firms offer, say, a five-year fixed maturity plan that has three variants- a conservative plan, a balanced plan and an aggressive plan. A conservative plan would have only bond exposure. The balanced plan will have 50 per cent in bonds and 50 per cent in equity while an aggressive plan will have 60-75 per cent equity exposure.
Portfolio managers can also offer Constant Proportion asset allocation strategy that shifts between stocks and bonds depending on the stock price movements. Aggressive portfolio managers can offer tactical asset allocation strategy to take advantage of their view on the bond and stock markets.
It is more advantageous to the investor if asset management firms offer equity exposure within a fixed maturity fund rather than have a fixed maturity equity fund. The reason is that the portfolio manager will take responsibility for the asset allocation process.
Such products can help investors’ optimally horizon-match their liability structure. An investor wanting to buy a house, fund her child’s education or buy a round-trip ticket on a European cruise can then use fixed maturity plans with appropriate asset allocation strategy.
B. Venkatesh
(The author is an investment strategist. He can be reached at enhancek@gmail.com)
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