December 20, 2011
The outcomes from this strategy differ from the case in which we simply buy the ATM call, in that the investor obtains greater exposure to the index (a higher participant rate), but the upside potential is capped. In the median outcome (the 50th percentile), the annualized rate of return is higher but the potential upside (the 95th percentile) is much lower. Generally speaking, this approach provides the highest level of capital preservation, along with the highest median return.
There are, of course, many permutations that are possible depending on how far the strike of the OTM call option is from the current price of the index.
Next, I will compare the three strategies in the case in which the investor is guaranteed that his or her original investment amount, of $100,000, will be returned at the end of two years.
Comparison of the three strategies
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|
Percentile Outcomes for Total Return |
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Strategy |
Minimum Final Value |
5% |
25% |
50% |
75% |
95% |
Average Return |
Long CD, Long S&P500 |
$99,992 |
0.9% |
1.3% |
1.6% |
1.9% |
2.3% |
1.6% |
Long CD, Long ATM SPX Call |
$99,994 |
0.0% |
0.0% |
1.2% |
3.4% |
6.4% |
2.0% |
Long CD, Long ATM SPX Call, Short OTM SPX Call |
$99,998 |
0.0% |
0.0% |
2.0% |
3.2% |
3.2% |
1.7% |
For the two-year term, all three alternatives have higher average returns than a pure investment in the CD (1.4%) because of the additional variability in the returns.
These are the baseline scenarios that can be used to evaluate an EIA, with a few caveats. First, as noted above, you must adjust for the fact that EIA returns do not include dividends. Second, these projections do not include any fees that advisors may impose. Third, these projections are for a two-year time horizon, and the investor must construct a new portfolio every two years.
Discussion
The challenge for potential EIA investors is figuring out whether they are likely to end with a benefit net of fees.
There are a number of benefits to constructing an EIA equivalent. First, the costs are entirely transparent and will be very low. Second, the principal component can be FDIC insured (in the case of a CD) or would be very low risk (in the case of municipal bonds). While highly-rated insurance companies have very little default risk, it is inarguable that these two alternatives are less risky. Third, while there are high expenses for early termination of an EIA, we can construct the EIA equivalent on any term that we desire. An investor who creates successive two-year investments has the option to exit with no cost at the end of each two-year period.
Some investors are prone to demanding liquidity in times of adverse market movements, and they cannot tolerate the volatility in the equity markets. For these investors, the EIA (or other variable annuities) may preferable, since the investor is forced to remain invested in order to avoid paying surrender penalties.
One of the additional factors that need to be considered, of course, is taxes. An annuity is tax-deferred until you begin receiving interest. You may have to pay a tax penalty if you withdraw funds before you age 59½. When you draw your money out of the annuity at the end of the term, it is taxed as ordinary income. If you invested in either an S&P 500 index fund or a call option on the S&P 500 with a term longer than one year, the gains will be taxed as long-term capital gains. The current 15% Federal tax rate on long-term capital gains makes the DIY EIA very attractive, as compared to tax rates on ordinary income.
For investors whose primary goals are principal protection, but who also seek some potential for gains due to market appreciation, the simple alternative of buying a CD and an SPX call option is relatively attractive. The average expected return for the two-year alternative is 2%, but there is a 1-in-20 chance of having annualized return of 6.4% if the S&P500 rallies.
Rates on CDs are very low, and options prices are quite high today, reducing the appeal of the DIY alternative relative to an EIA. Investors who choose the EIA need to understand all of the constraints associated with it. Market conditions will change the relative attractiveness of different levels capital preservation. The model that I have created to calculate the levels of capital preservation vs. upside potential is simple to maintain. Performing this analysis every two years and reconstructing the DIY EIA forward through time should be the standard against which any EIA should be compared.
Geoff Considine is founder of Quantext and the developer of Quantext Portfolio Planner, a portfolio management tool. More information is available at www.quantext.com.
Geoff’s firm, Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors.
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