Those double-digit stock market gains of the 1980s sure look sweet now. Eager as investors are to share in the wealth should stocks soar like that again, they are understandably edgy after losses this year.
For the skittish, there is an alternative: investments that link returns to market gains but that guarantee the principal will be returned-even if markets decline.
The investments are marketed by some of the biggest brokerage firms and banks. Lehman Brothers, Merrill Lynch and PaineWebber have versions, as do Bankers Trust, Citibank and Charter One Financial of Cleveland.
On Wall Street the financial instruments are known by acronyms such as MITTs, SUNs and SIRs, while Citibank calls its version the stock index insured account.
No matter their names, the precept is the same. The banker or broker agrees to pay back an investor’s principal at the end of a fixed period. And any investment gain is linked to the performance of a pool of stocks, like the Standard & Poor’s 500 index.
If the index rises sharply, investors will get back considerably more than they invested. If it goes down, the fall is relatively painless, because the principal is returned.
“They’re like mutual funds with training wheels,” said Steve Bodurtha, director of global equity derivatives at Merrill Lynch. “They’re meant for investors who are afraid of the risk in stocks, but want the potential of higher returns than they’re getting in interest-bearing accounts.”
Bodurtha’s job title gives away an image problem. These investments are, gulp, derivatives. But they are a far cry from the risky derivatives tarred by big losses early this year. Derivatives are a broad category of financial instruments whose value is derived from the value of an underlying financial instrument, like a stock or a bond.
In the two years since the plain-vanilla derivatives became widely available for consumers, their reception has been mixed. Citing weak response, the Republic Bank of New York, the Shawmut Bank of Boston and Hartford, and Nationsbank of Charlotte, N.C., abandoned them.
Yet Bankers Trust, one of the original developers, said its version had attracted more than half a billion dollars. Admittedly, that money came from wealthy customers. Anyone who wants to buy a Bankers Trust deposit linked to the stock market must pay at least $100,000.
But the bank apparently sees a future in the business, since it has now put together a deposit linked to an index of Latin American stocks. Investment minimums (though generally much smaller than Bankers Trust’s), hefty penalties for early withdrawal and an unusual structure are cited as stumbling points to broader sales.
And even if investors can’t lose, they may not always win. Financial consultants sometimes argue that investors start out in the hole because they usually give up the guaranteed interest, however modest, of a bank certificate of deposit.
Critics, in fact, liken the investments to earlier CDs that linked investment performance to things like snowfall amounts and Super Bowl victories. “They’re gimmicks,” said Jeffrey Franklin, a financial planner in New York. “Illiquid, inflexible gimmicks.”
Supporters, however, include Tanya Beder and Leslie Rahl, partners in Capital Market Risk Advisors, who advise companies on derivatives and are known as rocket scientists in their field. The partners say the investments can bring safety and diversity to an individual’s portfolio.
Rather than going to a securities firm or a bank, Beder creates stock-index derivatives for her personal portfolio. For example, she might combine Treasury bills, which provide a fixed-income stream, and options on the S&P stock index, which allow her to profit if the market rises.
The effect is much the same as the Bankers Trust deposit, she maintains, but at a lower cost. She need pay only a regular brokerage commission on the option.
Target-term securities
For the off-the-rack shopper who wants to avoid the harsh withdrawal penalties from banks, the Merrill Lynch market index target-term securities, or MITTs, are a good introduction.
They cost $10 each on their offering date, have no minimum and require only a brokerage fee. The first MITT came out in 1992.
At the end of the securities’ term, which is five years, investors are guaranteed their principal plus 115 percent of any gain in the S&P 500 index. As with stocks, small investors can bail out of these securities at any time for just a brokerage fee.
The game may be even better for players who come to the table late. Because these securities trade like stocks, investors may buy at any time, use a discount brokerage and perhaps pay less than the offering price.
Why does the MITT pay more than the 100 percent gain of the S&P? To help make up for lost dividends. Dividends on the index are now just under 3 percent a year-not a small loss when compounded over years.
Not all the securities are linked to the same index. PaineWebber offers stock index return securities, or SIRs, based on the Midcap 400.
The bank versions provide the added comfort of federal deposit insurance. Charter One offers three-year and five-year deposits that return 100 percent of the gain of the S&P 500. The guarantee extends beyond the principal to include annual returns of at least 4 percent.
That is richer than the Bankers Trust market-linked deposit, which returns 75 percent of the gain in the index over three years.
With the Citibank version, customers will get a return based on a complex formula that makes direct comparison difficult. Citibank pays twice the average monthly gain in the S&P 500 index over the 60-month period. Its deposit is available only for retirement accounts and has a $5,000 minimum.
Wall Street firms are busy constructing variations on the theme. Their newest versions are tied to a narrow category of stocks or even to a single stock.
Last year, Lehman Brothers offered stock upside note securities, or SUNs, based on an index of global telecommunications stocks, with the principal guaranteed.
Among the single-stock issues, Morgan Stanley issued a security linked to Telefonos de Mexico in September. Such securities sweeten the pot by promising annual interest, but they place a cap on how much the securities can appreciate.
Don’t be fooled, though. Unlike the investments tied to broad market indexes, these single-stock derivatives provide no guarantee of the original investment. They are not suitable for conservative investors.
