By DAVID MOON, Moon Capital Management
Wall Street is once again touting equity-linked CDs, the investment product
often hailed as the cure-all for the person who wants to be in stocks, while at
the same time not wanting to be in stocks. These things used to pop up
every two or three years, but this ill-designed derivative instrument now seems
to raise its very misleading head about every year.
Here is the sales pitch: put your money in an FDIC insured CD. If the
stock market goes up, you 'participate' in the return of the stock market.
If the S&P 500 declines, you are guaranteed to receive your initial
investment. Sometimes, the underlying CD will even promise a minimum
return, regardless of the return of the S&P 500. (These products are
now being offered linked to the returns of other underlying investments, not
just the S&P 500. You can buy CDs linked with the price of gold, the
Japanese stock market or other numerous markets.)
A recent guest on a popular investment television show recommended that these
types of CDs should be a core investment in everyone's portfolio. A
disclosure that accompanied his appearance revealed that he did not personally
own any of the CDs.
To evaluate these investments, you have to be able to figure out what the
meaning of 'is' is.
A bank in Denver offers typical terms. Its marketing materials tout the
ability to participate in the S&P 500 returns, while enjoying downside
protection. A review of the fine print reveals, however, that
'participate' has a specific and surprising definition. This particular CD
is credited with 90 percent of the capital appreciation return of the S&P
index, not its total return. This ignores the dividend return of the
S&P 500. If the total return of the S&P 500 is eight percent
annually, today's dividend yield would equal almost 25 percent of the total
return. Historically, the figure is as high as 35 percent. So you're
not getting 90 percent of the return of the stock market, you're getting 90
percent of 75 (or 65) percent. And depending on the other terms of the CD,
you might be getting even less than that.
The odds of the stock market declining over a five-year period are fairly
small, so the zero percent return guarantee isn't worth much. And if you
are forced to rely on the zero percent return guarantee, the real value of your
CD (adjusted for inflation) might decline as much as ten or fifteen
percent. That's better than experiencing both an investment and inflation
loss, but it is hardly the investment holy grail.
I have not reviewed every equity linked CD on the market. It is
entirely possible there are products that behave exactly as investors believe
they do. My condemnation of these products is that there is a major
difference in the way they are marketed and the way they are actually
structured. If you market or are aware of a product that satisfactorily
addresses the issues in this column, please let me know and I will write about
it. And if you own some yourself, I might buy some,
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).