Banks, brokers and (especially) insurance agents love to sell a product that has a very mouth-watering top line pitch: equity market upside without the risk of losing money. Unfortunately, the reason they love to sell these products is that the commissions to the salesperson are typically fairly generous and the economics of the product are attractive to the bank or insurance company underwriting the paper. These products go by various names, most commonly appearing in the form of an equity indexed CD, equity indexed annuity, or fixed indexed annuity. Due to the very simple construction of these products, they are actually quite easy and cheap to reproduce in under 30 minutes a year in your very own brokerage account, giving you much better returns and offering a lot more flexibility.
So how do these products work? I will illustrate the underlying economics of indexed products through discussion of a simple equity indexed annuity (EIA). Fixed index annuities and indexed CDs are virtually (if not exactly) the same product. An EIA is an insurance contract that theoretically offers the buyer the opportunity to participate (to some extent) in equity market performance while guaranteeing a minimum payout at the end of the policy guarantee period. The extent to which the buyer participates in equity market performance typically varies year to year as does the minimum guaranteed crediting rate (AKA interest rate paid on the policy). In the current interest rate environment, guaranteed minimum interest rates are generally quite low, on the order of 1% or even less. Equity market participation rates (the percentage of the equity market price increase that you would receive) varies considerably depending upon the cost of options on the equity index being followed by the product and whether or not your upside is capped. So an EIA might offer you a minimum return of zero (i.e. you won’t lose money if the equity market drops) and upside of 50% of however much the index (DJIA, S&P 500, etc.) increases over the next year capped at a maximum gain of 10%. What the bank or insurer actually does with the money you deposit into the product is as follows:
- Pay commissions to the agent of broker that sold you this product
- Pay premium taxes or deposit insurance fees
- Pay overhead expenses
- Buy a portfolio of bonds or make some loans
- Use some of the interest paid on the bonds/loans to buy options that recreate the equity market participation promised to the customer
- Keep the rest of the interest for themselves.
The problems with these policies have a number of problems for the investor: you have little control over how much you participate in the equity market; the policies typically have high early surrender fees and very lengthy surrender periods (10+ years is not uncommon); the internal expenses of these policies are quite high; you are exposed to insolvency of the insurer (not the case for index Cds due to deposit insurance); the participation is typically limited to price changes in an equity index, with no compensation for dividends on the index; the participation in the index is often capped at a predetermined level so that really big gains are truncated within the annuity structure; and the tax treatment of eventual distributions may be less than optimal. All of the preceding problems also leave out the one really huge problem: through the insurer or bank, you are paying big time expenses in the form of paying agents/brokers, taxes, fees, insurance company or bank overhead costs, and giving the insurer or bank a profit on your money for taking little or no risk.
Rather than offer (seemingly) everyone and their brother a chunk of your money for their efforts in selling you a wildly overpriced product, it is possible to “roll your own” EIA with little effort. In order to do this, you will need a brokerage account which is approved for options trading (ask your broker if you don’t already have approval) and a small amount of time (on the order of 30 minutes annually). It would also be a good idea if you read a basic primer on what options are and how they work if you are not already familiar with them.
How you can “roll your own” EIA, part 1:
By far, the simplest way to set up an EIA is to do it in an uncapped version. The simplest uncapped replication portfolio consists of a 1 year fixed income investment (such as a CD) and a call option on whatever equity index ETF you want exposure to. Since interest rates are so low on 1 year CDs as to make this strategy almost unworkable, we will assume you have bought a 5 year CD from Pentagon Federal Credit Union (www.penfed.org) at a rate of 2.25%. So let us assume you can buy a 5 year CD that yields (APY) 2.25%, you want exposure to the S&P 500, you have $100,000 to invest, and you want a minimum yield of 0%. To replicate an EIA, you would buy the following:
CD: You want $100k in a year, so you invest $100,000/1.0225 = $97,800 in a 5 year 2.25% yield CD. In a year, the CD is worth $100,000, which is your desired minimum payout.
Options: Your CD purchase leaves you with $100,000 - $97,800 = $2,200. You take this amount and buy at the money 1 year call options on the S&P 500 index ETF (ETF symbol SPY). At the money means that the option exercise price is about equal to whatever the ETF sells for today. So with SPY trading at $131.61 as I write this in January 2012, we wish to buy January 2013 calls with a strike of $135 (the next closest strike). January $135 2012 calls (http://finance.yahoo.com/q?s=SPY130119C00135000) sell for $8.09 each and must be bought in contracts on 100 shares each, so you want to buy $2200/$890 = 2.72 contracts, but must buy 2 contracts for $1,618.
So you end up with a CD that will be worth $100,000 in a year, $582 in cash left over from CD interest less what you spent on the calls, and options on 200 shares of SPY struck at $135. The options cover a notional amount of $135 X 200 = $27,000, so your “participation rate” in the index is 27,000/100,000 = 27%, meaning that you catch 27% of the appreciation of the S&P 500 through next January while bearing none of the downside. When the options are about to mature, you can sell them for cash, assuming the market has gone up and they are worth anything. Otherwise, your CD is worth $100,000, have your $582 in cash plus whatever interest it generated, and decide if you want to play this game again for another year.
Rolling your own, part 2:
Instead of having a small, uncapped participation in the index, you could have a larger participation but cap the amount of upside you would receive in a big bull move in the market. This is essentially what is done inside the EIA contract sold by most insurers. To replicate the EIA, you would buy the same CD as in the above example. However, the options portion would include:
1) Buy the at the money call options on the index as in the above example
2) Sell out of the money call options for the same expiration date and underlying ETF.
An example will be helpful:
Lets assume that you would be willing to cap your upside in return for a higher participation rate. That means you want to buy call options at the money ($135 strike) and sell call options at a strike that is about 10% higher ($150 strike). The $150 strike options currently trade for about $2.38 a share. So we buy:
3 contracts of the at the money options (http://finance.yahoo.com/q?s=SPY130119C00135000) for 300X$8.09 = $2,427
And we sell:
3 contracts of the 10% higher strike $150 (http://finance.yahoo.com/q?s=SPY130119C00150000) and receive cash of 300X2.38 = $714.
Total out of pocket for the options is $2,427 - $714 = $1713.
So you end up with a portfolio that consists of a CD that will be worth $100,000 in a year, $487 in leftover cash, and a package of options that gives you up to 10% of the upside on 300 X $135 = $40,500 worth of the S&P 500 index. Note that by capping your potential upside you have increased your participation rate to $40.5% of your $100,000, or one and a half times the uncapped version. Note that if you kicked in an additional $100 you would be able to have 4 contracts in the capped version, which would offer 54% capped upside participation in what the S&P 500 does.
If this is done in a taxable account, the CD interest will be taxable and so will the gains or losses on the options. In this case, you would want to set up the portfolio for at least 1 year and 1 day to qualify for long term cap gains on the options. So instead of buying a 1 year CD, perhaps you would buy an 18 month CD and options that expired in 18 months. Inside an IRA or other tax sheltered account this would be of no concern, but your broker may not allow you to set up the capped EIA replication inside an IRA.
Other odds & ends:
- I have ignored transaction costs here. The CD should cost you nothing. Most discount brokers will charge less that $20 for an option trade.
- Note that you can buy options on any index you like that has an ETF with options traded. That means you can do this with bond ETFs, intenational ETFs, sector ETFs, and so on. If you choose an individual stock with sufficiently liquid options available, you could even create an EIA replica with participation based on a specific stock.
- While I believe that it is easy and cheap to “roll your own” EIA, it is worth considering whether this strategy is a sensible choice for you as an investor. If you are so nervous about equity market exposure that a strategy like this is the only way you would want exposure to equities, perhaps you should entirely avoid the equity market. Alternatively, there are other investment vehicles that might offer similar performance and risk over long periods of time, such as a balanced mutual fund or a convertible bond fund.