An adviser compares a three-year note paying 100% of the index's price rise, with no protection, against a plain index fund. The index yields 1.3% a year in dividends. What does the note holder give up, and how do you explain it to the client?

The note holder gives up the dividends, about 3.3% over three years after the fund's costs, and takes on the issuer's credit risk for nothing in return. The note pays the index's price change; the fund earns price change plus dividends. If the index rises 20%, the fund ends near Rs 62.00 lakh and the note at Rs 60.00 lakh, a gap of about Rs 2.0 lakh. The dividends are what the issuer keeps to pay for building and selling the note.

Think of renting out a flat. One deal pays you whatever the flat's price does over three years. The other lets you own the flat, so you get the price change and the rent. Nobody would call those the same deal. The Satpura 50 level is a price indexAn index that tracks only share prices. When a company pays a dividend its price drops by about the dividend, and the index drops with it.: it falls a little every time a member company pays a dividend, so a product tied to it misses the dividend stream entirely. The index fund owns the shares, collects the dividends and reinvests them. The note owns nothing; it is a promise by Bababudan Capital to pay the price change at maturity.

Compound 1.3% for three years: 1.013 cubed is about 1.0395, so dividends reinvested add about 3.95% to whatever the price does. Take off the fund's assumed costs of 0.2% a year and the net carry is about 3.34%. The gap is not a fixed number of rupees: it scales with the ending value, because the reinvested dividends ride the market with everything else. On Rs 50 lakh, the gap is about Rs 2.00 lakh if the index rises 20%, Rs 1.67 lakh if it is flat, and still Rs 1.50 lakh if it falls 10%, because the note passes the fall through one for one.

Three things, each worth naming. First, issuer credit riskThe chance that the company that issued a note cannot pay what it promised at maturity. The investor is an unsecured lender to the issuer.: if Bababudan Capital fails, the client is an unsecured creditor and may get back a fraction of the value, even if the index has doubled. The fund's shares sit with a custodian and survive the fund house failing. Second, liquidity: the note can usually be sold early only back to the issuer, at a price it sets. Third, tax: notes and funds can be taxed differently, and the current treatment of each should be confirmed with a tax adviser before comparing returns. A note that only replicates the index, minus dividends and plus credit risk, is the fund with a toll booth on it.

Keep it to two sentences the client can repeat at home. The note pays what the index price does; the fund pays that plus the dividends, about 3% more over three years after costs. The dividends are how the issuer is paid for making the note, so the note is worth considering only if it gives back something the fund cannot: capital protection, a buffer against falls, or extra participation in the rise. A note offering 100% of the price rise and no protection gives back none of those. The limit of this comparison is the assumed yield: if dividends were cut in a downturn, the gap would shrink, and the client should see both numbers as illustrations rather than forecasts.