As former President Ronald Reagan used to say, "There you go again." This time it's the re-emergence of complicated investment products by the financial services industry to assuage the fears of the investing public.
A re-packaged idea gaining traction in the aftermath of the recent crash is the market-linked certificate of deposit. It guarantees a CD rate of about 1.5 percent, while it also promises to pay half of whatever the gain in the S&P 500 index turns out to be over the next five years -- if the latter is greater than the CD's rate.
Having your cake and eating it too? How do they do that? Simple. They take the invested funds and buy five-year, zero-coupon bonds and then purchase options on the S&P 500 Index for an amount that would generate enough gain to meet roughly half of the gain of the S&P 500. At the end of five years, they have enough money to meet whichever obligation would generate the most money for the investor.
In return, the investor enjoys five years of uninterrupted sleep knowing that they'll make at least 1 percentper year even if the world goes to hell in a hand basket. If the market does take off, they'll receive close to half of what would have been their full rate of return as direct investors in the S&P 500 Index.
So, is this a good deal? That depends. The answer begins with breaking the investment into its component parts. We know what a CD paying about 1 percent per year is worth, and it's insured by the FDIC up to the usual limits. What happens when we combine itÂ with an agreement to pay us half of what the S&P 500 generates?
To begin with, to say it is half is an over-simplification. it's not exactly half. It is the average increase in S&P 500 value over the five-year period. The average increase, of course, would be half of the total if there was a straight line of increasing values. If the S&P 500 went from 1,000 to 1,500, the average would be 1,250 and the profit would be $250 on a $1,000 investment.
In reality, the increase is calculated each quarter and it's a cumulative collection of averages that gets added up. The index could get to the $1,500 by the end of the period and generate more or less than the $250 profit depending on what had been happening from quarter to quarter. Also, this program gives up whatever dividends might have been paid --- there is no credit for dividends reinvested. Finally, there is typically a 3% placement fee which means that out of a $1,000 investment, only $970 is actually invested.
Is not losing any money, even for a moment, worth giving up half of what could have been our gains from investing directly in an S&P 500 Index fund? Over any rolling, five-year period, the index has rarely lost money. In rolling 10-year periods, we were able to say, for many, many years, that it had never lost money except for one year back in the 1930's. Over the last five years, ending in August of this year, the loss was just 2.5 percent and that included the greatest market crash since 1929.
Meanwhile, if we give up dividends, we're really getting less than half of what could have been earned by direct investment in the index assuming that dividends had been reinvested. From 1950 through 2009, the average price change of the S&P 500 was 7.2 percent and dividends averaged 3.6 percent for a total return of 11 percent. The investor during that time experienced a real roller coaster from year to year, but over almost all rolling five-year periods, they would have made money.
In a market-linked CD, by comparison, the same investor would have received half of the price change or 3.6 percent and no dividends. True enough, in some five-year periods, when the market had lost money, the rate on the CD could have been higher than the payout generated by the average gain of the index.
However, assuming that this happened rarely, the advantage of the direct investment more than compensates. Why? The $1,000 per year invested in the market-linked CD program (at 3.6 percent) would have accumulated to about $200,000 over 60 years.
The same $1,000 invested directly in the S&P 500 with dividends reinvested would have accumulated (at 11 percent) to almost $5 million.
Compressing this past history to a more meaningful time period, anyone with even just a 10-year horizon on an initial $10,000 investment would be about $12,000 ahead with the direct investment if the 3.6 percent versus 11 percent history repeats itself. I don't know about you, but I can afford to lose a little sleep for that kind of money.