From a retiree: “What do you think of Market-Index Target-Term Securities for a tax-sheltered account? I just read a brief article discussing the advantages of MITTS over options to protect one’s principal in securities. If they are a reasonable investment for one already retired, where should I look to obtain the details of each?”
A.T.: Investment firms are constantly looking for creative ways to get their MITTS on people’s cash, and most of these ideas are — to steal a joke from my wise friend Less Antman — NUTS (New and Untested Terrible Strategies). MITTS aren’t the worst idea in the financial universe (selling naked puts is the worst idea), but they are very expensive insurance against a very unlikely scenario.
Briefly, MITTS are derivative securities — a manufactured product like gefilte fish, which is not an actual fish (“I caught a gefilte fish!”) but derived from fish. They promise to pay at maturity an amount no less than they were issued for — and no higher than some specified ceiling. Just how well you do within that range depends on the performance of some market index. As an example, Merrill Lynch’s Technology MITTS were issued in August of 1996 at $10 per unit and promise to pay between $10 and $20 to the holder at maturity in August of 2001, depending on the performance of the CBOE Technology Index. No downside risk (ignoring inflation) in exchange for limited upside potential.
So far, so good, but there is more to it. The payoff is not based on the increase (if any) of the index over its price in August 1996, when the securities were issued, but on the increase over 112.5% of the index, so that the buyer gives up the first 12.5% of appreciation. Also, since the index doesn’t reflect dividends (which are admittedly small, but might make up 1% a year over that time), the owner also gives up around 5% more. Thus, you are giving up about 3% per year over the 5-year life of the product. If owning the stocks directly might have earned you 10% a year, now you will earn more like 7%. You will have $1.40 for each dollar you started with instead of $1.61.
And you are limiting your gain to an absolute maximum (in this example) of 14.87% a year, which is what $10 growing to $20 in five years represents.
The insurance MITTS provide is expensive because the stock market rarely loses money over a five-year period. (In fact, notes my friend Less, a mixture of 50% U.S. stocks and 50% international stocks has never done so, even with a start year for the investment of 1929.) Of course, going forward, anything’s possible. (“In the entire history of this city,” you can just hear the San Francisco real estate agents reassuring prospective buyers in 1905, “there has never been an earthquake that caused really serious losses.”) So there could come a time MITTS buyers have the last laugh.
To play it safe in retirement, consider putting equal amounts into a broadly diversified U.S. stock portfolio or index fund … a broadly diversified international portfolio or index fund … and a short-term bond fund.