From the January 2004 issue of Investment Advisor • Subscribe!

Back to the Future

Forget hedge funds. If you want a real alternative investment, pick something exotic like a market-linked CD, says Ed Winslow

Financial planner Ed Winslow's book, Blind Faith, was published in June 2003, but the idea for the book started "percolating" in his brain some six years prior. It was around that time, he says, that he started to change his own philosophy about investing. As his financial planning clients approached him in the middle of the long bull market to ask if they should put more money into mutual funds and individual stocks, Winslow "stepped back, looked at the big picture, and thought, there's got to be a better way to handle this from a risk-management standpoint."

The result was that Winslow, who became a CPA in 1976 and an investment advisor in 1982, decided to educate himself about--and direct clients to invest in--market-linked certificates of deposit, equity-index annuities, and equity-linked notes. Winslow talked to Editor Jamie Green about how these products work.

Was there anything special about your clients or about your practice that led you to focus on these vehicles (market-linked CDs, equity-index annuities, and market-linked notes) at a time when most clients would have been clamoring for greater returns rather than more risk management? I started a brokerage firm in 1985 by the name of First Affirmative Financial Network, which specialized in socially responsible investing. In the mid-1990s I sold that broker/dealer to an insurance company. Instead of being in a management position supervising brokers, I was back to doing what I really enjoyed--working with individual clients. The types of clients that I had were interested in social investing. They weren't your average investors who were just seeking the highest return possible. They were open to different ideas, and the idea of being financially responsible as well as socially responsible. A lot of them had a basic mistrust of corporate America and the stock market to begin with.

Speaking of mistrust, what's your take on the mutual fund scandals of today? Are you angry? Before I got into this business I worked for an insurance company, and I had this risk management stuff drilled into my brain. The way I look at all these scandals, and even the mutual fund stuff, is that these are just hazards from a risk management standpoint. They increase the possibility of loss. The best way handle a hazard is to have protection against loss . . .

...and to get a third party involved that will help to spread that risk? I think the most valuable part of the book is chapter 6, where I talk about risk management. There are four ways to handle risk: You can avoid it, which means you don't participate in the stock market at all. You can accept it, and invest in equity mutual funds and stocks. You can attempt to control it, which is the way we investment advisors are trained to handle risk--we do asset allocation, diversification, and, most importantly, we have this long-term time horizon and an underlying assumption that the market always goes up. The last way, which we hardly ever do, is transfer that risk to a third party. That's what we are doing when we utilize instruments like a market-linked certificate of deposit, or a market-linked note: The risk is being transferred to the bank or the brokerage firm.

From the investor standpoint, that risk has been transferred, and they have insurance against loss, yet still have participation in the upside of the market. That makes a lot of sense to me from a risk management standpoint. When you look at all the scandals, well, what do you do in that environment? This is one way to handle it.

First of all you want to retain their principal. "First, do no harm," right? Yes, and to look at investing from a different perspective. I look at mutual fund and stock market investing more as speculation, because you can lose your principal. It's the definition of gambling. If we can build upon our principal over time, and assure our principal isn't going to be lost, that's the way I would personally rather invest.

I like to use this analogy. You know those state quarters that are being issued now? Well, you could have bought a roll of New Jersey quarters for $10 from the bank when they were first issued in 1999, and now they're selling for $30. That's the perfect growth investment from my standpoint. You've got protection of principal, and your $10 roll of quarters is always going to be worth $10 and could increase in value. This is essentially a manufactured collectable from the U.S. Mint that could increase in value over time, but even if they don't, then you have your $10.

You did have an opportunity cost: You could have had that $10 earning interest in a money market account, for instance. I like to use that analogy with clients; it's easy for them to understand.

You said that part of what motivated you to write the book was that there wasn't a lot of information about these products. Could you talk a little bit about them? The three big ones are market-linked CDs, market-linked notes, and equity-index annuities.

Market-linked CDs are issued by banks, are FDIC-insured, and are like a traditional CD, except in the way that the interest is calculated. There are many different variations of these CDs, and every time one is issued there is a different quirk to it. You have to look at the offering terms on the CD to know exactly what you are getting.

In general, you have a return that's based on the change in the underlying index--the most popular being the S&P 500 index. Probably 50% of the market-linked CDs that have been issued are based on the S&P 500. The bank issues the CD and gives this guarantee, then buys a combination of a zero coupon bond and a call option on the underlying index.

Say it's a five-year CD: The bank buys a zero coupon bond that assures that the original principal is going to be returned five years from now. Say that cost is 80 cents on the dollar. The other 20 cents is put into a call option on the S&P 500. Depending on where interest rates are, and the volatility of the market, and what that option cost, the bank knows what kind of guarantee it can give to the client.

In the 1990s, interest rates were higher, volatility was okay, and the options weren't real costly. You can actually buy some of these CDs and get back more than what the underlying index [returned]. This is when I really got interested, because this seemed like a no-brainer.

These [products perform like] an index fund, but with a guarantee against loss. With interest rates so low today, the CDs have to be longer term for it to make sense. They have to be 10 or 11 years to give 100% of the change in the underlying index. If it's a shorter period of time, the issuers have to put caps on the CD or they have to do something else to limit the return. But these CDs still make sense for the conservative investors, and they make sense for people who would otherwise not be in the stock market at all. Rather than get a really low rate with a traditional CD, here they have the potential to get a much higher return.

Market-linked notes (or equity-linked notes) are essentially the same concept--the zero coupon bond and the call option--but they are issued by brokerage firms under various names. They protect principal, and return is based on a change in an underlying index. The only thing different is that they're not FDIC-insured--you are just a creditor in the brokerage firm. Merrill Lynch, Smith Barney, UBS PaineWebber, all the larger brokerage firms have issued a lot of these.

Market-linked notes essentially work the same way, but once they're issued by the brokerage firms, they trade in the secondary market. There are a lot of them listed on the American Stock Exchange. If you look on the American Exchange Web site (www.amex.com) under "structured products," you'll find a lot of market-linked notes trading there.

So they are pretty liquid? They are. It's better to buy them in the secondary market than directly from Merrill Lynch, because they immediately trade at a discount [when issued]. The big brokerage firms don't really support them once they are sold. It's like the old limited partnerships, or the ones issued even now. You can pay 100 cents on the dollar directly from Boston Capital or you can buy it in the secondary market at 80 cents on the dollar.

Equity-index annuities are the insurance companies' variation of the notes. Interestingly enough, they are not considered securities: A person doesn't need a securities license to sell an equity-index annuity.

That's kind of controversial; there's talk between the NASD and the state insurance departments whether this is a security or not. That talk will be going on for quite a long time, but right now it's just an insurance product. Another interesting thing with the equity-index annuities is that many of them now base the gains on a daily average, not a point-to-point method like the CDs and notes. On a yearly basis, if there is a gain, they will lock in the gain, and if there is a loss, then there's not a deduction from the account. The more often you lock in the gain on these things, the better, especially if the market is volatile.

It would have been really nice to have been in an equity index annuity in March 2003 when the S&P was hanging around 800. Even on a daily average basis, you are probably going to have a 20% gain for the year when the anniversary date comes up March 2004. Then you can switch to a fixed account, and there are various indexes you can choose from: the S&P 500, the Dow, S&P 400, Nasdaq.

The main thing with all of these products is that your principal is guaranteed and protected regardless of what happens with the market--in the case of the CDs and the notes, as long as you hold them to maturity. In the case of the annuities, it's usually a yearly calculation.

What are the drawbacks of these products? One of the biggest is the tax treatment. The notes and the CDs generate a 1099-OID. You can be holding this CD for five years and you're not getting a return until the end. In the meantime, you're getting a 1099 showing that you're earning interest on the instrument.

Also, any gains that you make on these are considered interest. Unless they go up tremendously and you sell, you are not going to receive capital gains treatment for tax purposes. So these are best housed in a retirement account.

Currently, another negative is that with interest rates so low, if the market goes up tremendously you may not get 100% of what the market does, you might only get 60% or 70%, depending on the term of the CD or note. The shorter the term, the less participation you are going to get.

Blind Faith: Our Misplaced Trust in the Stock Market and Smarter, Safer Ways to Invest was published in 2003 by Berrett-Koehler Publishers, and is available through the Investment Advisor bookstore, at www.investmentadvisor.com.

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