Glassman Redux! Eureka! We are apparently talking derivatives here! I found one column written last summer(see below), about something called MITTS. And yes, you are paid full market value if your index goes up, and returned your full purchase price if your index goes down. I got this article for free (thanks to Metacrawler). The link, however, has expired, so I am posting the article in full. Will post later columns on this general subject as I track them down. Read on!
jbe
MITTS May Be Answer for Market
Anxieties
By James K. Glassman
Washington Post Staff Writer
Sunday, August 24, 1997; Page H01
Up a hundred points, down a hundred points. . . . In this
tumultuous market, many small investors are reluctant to
commit any new money without a sense of security. At such
giddy heights, fear of losing a bundle is not unfounded.
But what if I told you that there's an investment that will give
you no downside but an unlimited upside? An investment
with a guarantee against loss but no restrictions on gain?
In fact, there are several such investments trading on the
American Stock Exchange; they're low-priced and easy to
buy and sell -- just like shares in General Electric Co. or
Microsoft Corp.
These securities, which are actually (gasp) derivatives, vary
in their details, but a typical one works this way: If the
Standard & Poor's 500-stock index, a popular market
indicator, goes up, you get the entire increase, often plus a
bonus. If it goes down, you get your initial investment
returned in full.
Talk about having your cake and eating it too.
Most of these investments are issued by Merrill Lynch & Co.
and are called MITTS, or market index target-term
securities. Although the first MITTS were launched five
years ago, few investors are aware of them. All MITTS have
an expiration date, and that first series closed just last week,
but don't worry, there are at least a dozen more being
actively traded, with new ones -- including a MITTS geared
to the Russell 2000 index of small-cap stocks -- on the way.
To give you an idea of how the typical MITTS works, let's
look at the first one:
In January 1992, Merrill sold shares of this MITTS (its
symbol on the AMEX is MIT) for $10 apiece to the public.
Each share carried a promise to pay, in August 1997, an
amount equal to the percentage increase in the S&P 500
over that period, plus an extra 15 percent of that, times $10 --
and the original $10 back. There was another promise: If the
S&P was lower in 1997 than it was in 1992, investors
wouldn't be penalized. Merrill would still return the $10
initial investment.
When the shares were issued, the S&P was 412. On
Thursday, it was 925. That's an increase of 125 percent.
Add 15 percent of that and you get a total increase of 143
percent -- times $10 equals about $14 per share. Add the
original $10, and the shares are worth $24, which is exactly
how they stood on the AMEX at week's end.
Like all stocks, you don't have to buy MITTS when they are
issued. You can buy and sell them at any time, using any
broker. MITTS are listed in the AMEX table (look under
Merrill Lynch, or ML).
They come in lots of flavors. Merrill, for instance, offers
MITTS linked to a technology index (symbol: TKM), a
health care index (MLH), a European index (MEM) and
more. A new inflation-adjusted one will guarantee that
investors get their $10 back plus an adjustment for increases
in the consumer price index. Bonuses (if any) for all these
MITTS vary.
PaineWebber Inc. sponsors what it calls "stock index return
securities," based on the S&P 400 index of mid-cap stocks
(symbol: SIS). And Salomon Brothers Inc. has a
MITTS-style Nikkei security (NXS) due in 2002 that pays
the increase in that Japanese index plus a 42 percent
bonus.
Last year, Merrill launched MITTS based on the popular
Dow 10 strategy of investing (buy the 10 stocks with the
highest dividend yields among the 30 Dow Jones industrials;
repeat the process each year). Unlike S&P MITTS, these
shares (MTT) carry no bonus, but they do have the same
$10 guarantee.
So what's the catch? There are several, but none is
especially significant:
First, these shares (or, technically, "units") are obligations of
Merrill Lynch -- or any other issuing company, or even
country (the first series of S&P MITTS-like securities was
sponsored by the government of Austria). If something nasty
happens to the issuer and it can't make good on its
guarantee, then you're out of luck.
Think of these securities as debt. After all, Merrill Lynch
calls them "protected growth notes." You lend Merrill $10
and, instead of paying you, say, 7 percent interest a year,
the company pays you "contingent interest" in a lump sum
at the end of several years. The amount is contingent, or
dependent, on what happens to the S&P 500. (Thus, the
units are derivatives since their value is derived from
something else.) And of course, as with any debt, Merrill
promises to give you your principal back. America's top
brokerage firm, with an excellent credit rating, could
default, but the chances are remote.
Second, there's a tax problem. The federal government now
treats MITTS as though they were zero-coupon bonds (some
earlier MITTS escaped that designation). "The investor has
to accrue interest income," Robert Willens, a tax specialist
who follows MITTS for Lehman Brothers Inc., told me. In
other words, you pay taxes (at the ordinary income rate,
which can hit 39.6 percent) on "phantom interest" -- the
amount of which is determined according to a complex
formula. It could easily be 7 percent or 8 percent.
For that reason, it makes sense to hold MITTS in
tax-deferred accounts, such as IRAs or 401(k) plans.
Third, Merrill guarantees only that investors receive the
initial offering price back, not the current trading price. For
example, a MITTS series that's due in 2001 (symbol: MIX)
was trading Friday at $13.56 per share. But four years from
now, if the market has erased these gains, Merrill will only
return $10. For that reason, you may be more comfortable
buying more recent issues, such as the series with the
symbol MIM, due in 2002 and now trading at $10.50. Or the
new small-cap, European and inflation-adjusted MITTS.
Fourth, you get no dividends. If you own an S&P-based
mutual fund, such as Vanguard Index 500, you receive
payouts that are immediately reinvested as shares in the
fund. Here, you get no payout. And even in this low dividend
environment, the money you forgo can exceed the 15 percent
kicker -- especially if stocks are zooming. For example, while
the S&P gained 125 percent over the life of that first MITTS,
its return (with dividends reinvested) was about 160 percent,
according to Bloomberg News.
Finally, understand that Merrill and the other firms that
offer these investments aren't charitable institutions. While
MITTS seem too good to be true, they aren't. For instance,
even though you get your money back if the S&P drops, you
get no interest, and Merrill has had the use of your money
for several years.
History also shows that the stock market doesn't fall that
much. Ibbotson Associates Inc. examined every five-year
cycle since 1926 (i.e., 1926-31, 1927-32, etc.) and found that
the S&P suffered a decline in only seven of 67 periods. If that
pattern holds, then Merrill's odds of having to pay back the
full principal despite a drop in the S&P are roughly one in
10.
But, then again, the pattern may not hold, especially in a
market that many analysts believe is seriously overvalued.
"This is not a bad deal at all," says Willens. "What investors
love is getting their principal back."
Indeed, they do.
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