Investments

1Ways to classify investments

• Financial vs non-financial: non-financial = real estate, gold, commodities; financial = claims on future cash flows.
• By claim: debt and equity.
• By market: public vs private.
• By maturity: capital market (long term) vs money market (short term).

Remember

• Financial instruments are claims on future cash flows.

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2Equity and preference shares

Equity shares give ownership, profit sharing and voting rights. Shareholders are residual claimants, paid after all other obligations. Returns come from dividends and capital appreciation; over long periods equity offers time diversification, smoothing fluctuations and improving risk-adjusted returns.

Preference shares rank above equity for dividends and for net assets on liquidation, but usually have no voting rights. Like debt, they pay a fixed dividend; like equity, they can be perpetual. They are hybrid securities.

• Cumulative: unpaid dividends accumulate and are paid later. Non-cumulative: skipped dividends are lost.
• Non-participating: a fixed dividend only. Participating: the fixed dividend plus extra dividends under set conditions (and possibly liquidation preference).
• Convertible: can be converted into a set number of equity shares.

Voting: usually one share, one vote. DVR shares carry superior or inferior votes or different dividends. Permitted in India since 2000 but little used; Tata Motors was among the first (2008), with one-tenth the votes and a 5% higher dividend; others include Pantaloons Retail, Gujarat NRE Coke and Jain Irrigation.

Remember

• Preference: priority in dividends and assets, usually no vote.
• Tata Motors DVR: 1/10th vote, 5% extra dividend.

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3Fixed income: government and corporate debt, ratings

Debt (fixed income) instruments promise a stream of cash flows over their term. They may be transferable or not, and set the borrower's obligations and the holder's rights on default. Issuers: companies, municipalities, states and sovereigns. Government securities are the largest part of the debt market in India and worldwide.

G-secs are tradable debt of the Centre or states: T-bills (under one year, Centre only) and dated securities (over one year); states issue SGSs. They carry practically no default risk ("gilt-edged").

Corporate debt is a key funding source, much of it unlisted. Corporates pay more than government for the same maturity because of default risk; the difference is the credit spread (a risk premium). Higher default probability means a wider spread.

Ratings by SEBI-registered agencies:

BBB and above = investment grade; below BBB = high yield ("junk"), which many institutions are barred from holding.

Remember

• Credit spread = corporate yield − G-sec yield (same maturity).
• Investment grade: BBB and above.

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4Commodities

• Soft commodities (grown: corn, wheat, soybean, soybean oil, sugar) are perishable and volatile, exposed to business cycles and weather, and historically have low correlation with stocks and bonds, so they diversify a portfolio. Exposure is usually through forwards or futures, so investors must understand those risks.
• Hard commodities (mined: gold, silver, oil, copper, aluminium) are priced by global demand and supply. Gold and silver have been reserve assets for centuries; gold is a safe haven in uncertainty and crises and has diversified portfolios historically.

Commodities generally produce no current income; returns come only from price appreciation. (Lower correlation between investments means greater diversification benefit.)

Remember

• Commodities give no income; gold is a safe haven.

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5Real estate

Real estate is a major asset class and growth driver, offering diversification and historically a good inflation hedge. It can be bought for capital appreciation and rental income, usually as a long-term investment. Segments: commercial and residential, across tier I, II and III cities. It needs large commitments; real estate funds and REITs allow exposure with smaller amounts.

Remember

• REITs give real estate exposure in small amounts.

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6Structured products, distressed securities and other opportunities

Structured products are customised, sophisticated investments that use derivatives to create a desired exposure, often linked to indices, sectors, themed baskets, currencies, rates or commodities. Short or long term, they need large investments and may offer 0% to 100% protection and/or attractive yields, but performance depends on the strategy and markets, so they are not guaranteed or truly capital-protected products. The most common example is the market-linked debenture (MLD).

Distressed securities are equity and debt of companies in financial distress or near bankruptcy, often at deep discounts. They need advanced valuation and credit skills, suit experienced investors with risk appetite, are sometimes called "fallen angels", are barred for many funds and institutions, and are popular with hedge funds; PMS and AIF products exist.

Art, paintings and collectibles: moderate long-term returns with low correlation to financial assets, but big-ticket, each work unique, unregulated, no income, illiquid, and requiring specialist knowledge because of information asymmetry and adverse selection. Art funds offer exposure.

Overseas investing: under the Liberalised Remittance Scheme (LRS), individuals may invest up to US$250,000 a year abroad, gaining geographic and currency diversification.

Remember

• Structured products are not guaranteed-return products.
• LRS limit: US$250,000 a year.

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7Channels: direct investing and advisers

Direct investment: buying securities from companies and governments, or gold and silver from dealers, with help from fee or commission-based intermediaries (brokers, depositories, advisers).

SEBI-registered investment advisers (RIAs): under SEBI's 2013 IA Regulations, only qualified professionals registered with SEBI may act as "advisers", paid by investors. Distributors (MF distributors, brokers, insurance agents) can no longer call themselves advisers. RIAs are accountable only to their clients, follow a strict code of conduct, act in clients' best interests, disclose conflicts, do risk profiling, assess needs and financial health, prepare financial plans and instil discipline.

Remember

• Advisers are paid by clients; distributors cannot use the title "adviser".

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8Managed portfolios: MFs, AIFs and PMS compared

Investors can invest indirectly through professionally managed pooled or managed portfolios, gaining expertise at lower cost: mutual funds, alternative investment funds, portfolio managers and collective investment schemes.

AIFs and PMS assume investors understand complex strategies and risks, and are popularly called the "rich man's mutual fund".

Remember

• AIF minimum ₹1 crore; PMS minimum ₹50 lakh.