In the last couple months I have flown with three different people who were considering putting large amounts of money into a structured product. One was an Equity Indexed Annuity with an insurance company, another was a Structured Bond with a bank, and the last was called an Equity Linked CD with a bank.
All of these were similar in structure. Basically, you are guaranteed all (or most) of your principal back at the maturity date (the CD also had a small guaranteed interest rate). In addition you are able to participate in the upside of some stock index. All of these happened to be linked to the S&P 500.
To better understand what these are, here is an example of what one might look like:
We all know that stocks have been historically the best place to build wealth. However, as we have learned in recent years, stocks are risky and can have large losses. If there was only a way to participate in the upside of the stock market, while making sure you never lose any money. Well, today is your lucky day! With our new “Only UP” Annuity we are able to provide you with just that, upside participation without the risk of losing any money!
Here’s how it works. You give us a lump sum of money; say $1,000,000 for ten years. At the end of 10 years the absolute worst case scenario is you will get your $1,000,000 back. But your money will be able to grow along with the S&P 500 index. You will be able to participate in over 70% of the upside of the S&P 500 without ever having to worry about losing money…EVER! If stocks have a 20% return this year, then your money will grow by over 14% with ZERO risk of losing your principal. Alternatively you can receive 100% participation in the S&P 500 while capping your maximum upside all the way up to 9.5%. This means that if the stock market goes up 9% this year you will gain all 9% with ZERO chance of losing your principal. This is the deal of a lifetime, so call us right away!
Hopefully the insurance companies can do better than me with their marketing material, but you can see how something like this appears attractive to investors.
Now let’s see how we can replicate this ourselves without having to give our money to the insurance company or bank. The first thing we need to do is invest our $1,000,000 in some sort of bond portfolio in order to generate some income. Today’s low rate environment makes finding yield much harder today than in the past. If we look at investment grade (A and BBB) bonds with a term of 10 years we can build a portfolio of bonds that will yield us around 4% per year (finding a bond mutual fund that invests in A and BBB bonds with a duration of 10 years will also accomplish this). The default rate of investment grade bonds is historically much less than 1%; while not a 0% chance of losing money, it is pretty close.
So now we have a bond portfolio that will almost guarantee that we will get our $1,000,000 dollars back in 10 years and will also give us an annual income of $40,000. In order to “link” ourselves to the S&P 500 we will use options on the ETF SPY, which tracks the S&P 500 – call options to be exact. Call options are very simple. We will be buying the right to buy SPY at a specific price in the future. We can either choose to buy it at this price or not. Today (June 2015) the SPY is trading around $210. Let’s buy “at the money” call options with a strike price of $210 that expire in one year. This means we will be buying the right to buy SPY at $210 one year from now. If in one year the price of SPY is $230 we will exercise our right to buy SPY at $210. We can then immediately sell our shares we just bought at $210 for $230 and make a profit of $20. If the price of SPY is $190 in one year, then we will obviously choose to not buy it at $210.
Today the cost of this option is about $11.90 per option. Option contracts are sold in 100 option chunks. With $40,000 we will be able to buy about 34 contracts. In order to fully “link” our $1,000,000 portfolio with SPY, we need to buy about 48 contracts. This is why we are only getting about 70% of the upside (34 / 48 = ~70%). If we had a bond portfolio giving us a 5.7% yield, then we would be able to fully link ourselves to SPY.
We can participate 100% in SPY if we are willing to cap our upside. To do this we will have so sell an option along with buying one. If we sell a call option at the $230 strike price we can make about $3.40 per option. If for every call option we buy with a strike price of $210 (like we did above), we sell a call option with a strike price of $230. We have effectively reduced our net price of each call option to $8.50 (We buy one option for $11.90 but sell one for $3.40……$11.90 – $3.40 = $8.50). Now we can purchase all 48 contracts, so we will be able to participate 100% with SPY. However, if SPY gets over $230 someone will have the right to buy it from us for $230. Now we fully participate with SPY, but our upside is capped at 9.52% (the percent gain from $210 to $230).
Every year we will do this exercise again. Of course, it would be a little more complicated than this in practice since the bond income vary from year to year and changes in volatility will change the prices of the call options from year to year.
It should be said that you will NEVER be able to find a deal this good in a structured product today. Why? Because insurance companies and banks are subject to the same financial markets as we are. They have to deal with low interest rates and the same (or similar) option prices. And of course they will be charging a fee somewhere along the way. Usually they will take some percentage of the bond income for themselves, then use the rest to purchase the options. If they took a 1% fee each year then the new upside participation rate would be reduced from 70% to about 53%. Like I mentioned in my last article on structured products the people designing these products have already priced these out ahead of time and have designed them to make sure they get their fee, while providing you with their stated product.
Now that you know you can replicate these products yourself without the fees should you do it? NO, but that is for another post.
