Beware of investment hybrids

By DAVID MOON, Moon Capital Management
September 2, 2007

I must be one of a dying breed, but when I get ready to buy a new car, there are certain steps I take. I place an ad in the paper and send an email to every one I know telling them I have a car for sale. Then I sell my car. Then I buy another car. It seems pretty straightforward to me.

Years ago, someone taught me that trading cars with the auto dealer confused the process. It combined two transactions: selling and buying a car. And the guy on the other side of both transactions knew a lot more about the products than I did.

The combined transaction became a lot like a magicians' sleight-of-hand trick. By causing me to focus my attention where he wanted, the car salesman could easily obfuscate the true cost of the new car or the sales price of my old one.

If I split the transactions in two, it might be a little more work, but my simple mind could more easily grasp the overall net effect.

I thought about this when I saw a real estate ad in this paper a couple of weeks ago. If you buy the house, they will throw in a brand new red Porsche sports car to boot.

The ad didn't even list the price of the house or the number of bedrooms.

Are they selling houses or cars?

Think about this the next time someone tries to sell you an annuity because of the fantastic tax-deferred benefit of the investment component of the contract. Many annuities are a combination of an insurance policy and a collection of things that look like mutual funds ' wrapped up into a tidy tax-deferred package.

But just as the car salesman wants you to focus only on the payments or the amount he's giving you for your trade-in or the low, low price he's charging you for the new car, if you focus only on the tax deferral, you're missing the whole picture. It's like buying the house just to get the Porsche.

OK, so the earnings on an annuity are tax deferred. But at what cost?

Morningstar calculates that the average annual annuity expense ratio is 2.08 percent. This ignores any surrender charges or annual contract fees.

If the underlying investments earn 11 percent, the annual expense eats 18.91 percent of the annual return ' more than the current 15 percent tax on capital gains. Then, when you begin to withdraw earnings from the annuity at some point in the future, the gains are taxed as ordinary income, currently at rates as high as 35 percent.

Not so tempting. But by combining the insurance with the mutual funds, the annuity suddenly becomes tax deferred, and presumably more attractive. Well, maybe not more attractive, but certainly easier to sell.

Annuities aren't the only example of investment subtraction by addition. All sorts of contrived transactions are available to the willing buyer, including hybrids like certificates of deposit combined with index options, and convertible bonds packaged with stock puts.

It reminds me of some old country wisdom: a boy who chases two rabbits ain't likely to catch either of them.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

Add me to your commentary distribution list.

MCM website