Fixed-index annuities aren’t the only way you can invest in the stock market and be guaranteed not to lose money in the short term.
That’s because there is a do-it-yourself alternative to avoid the high commissions associated with Fixed index annuity (FIA). And it’s not particularly difficult.
I’m focusing on this do-it-yourself alternative for tracking last week’s column on strategies to immunize your equity portfolio from losses. As you may recall, in that column I mentioned a specific FIA that, in addition to guaranteeing you won’t lose money over a 12-month period, also pays you 55% of the stock market return. stock when it rises. In return, you lose all dividends as well as 45% of stock market returns.
Several readers have emailed me to say they don’t think this is a good deal. They argued that giving up nearly half of the stock market’s gains and all the dividends was too high a price to pay for not losing money in any 12-month period.
My answer to these readers: A higher participation rate can be secured by investing the majority of your equity portfolio in bonds and using the small remainder to buy call options only. cash amount that expires at the same time the bond matures. You are guaranteed not to lose money between the time you start trading and the date the bond and option expire.
To appreciate the promise of this approach, consider a simulation done a few years ago by Michael Edesess (adjunct professor at Hong Kong University of Science and Technology) and Robert Huebscher (founder Advisory opinion site). They assume that their hypothetical portfolio, every two years, invests 93.7% in high-quality corporate bonds maturing in two years and 6.3% in two-year call options in the next two years. month on the S&P 500. Assuming then- the popular two-year corporate bond yield (3.3%) and assuming the S&P 500 will generate an annualized rate of 8%, the plus-bond strategy This option generates an annual return of 5.4% over the simulated 12-year period.
Note carefully that the maturity of the bond and expiration option you choose is equivalent to the “reset time” that the FIA guarantees you will not lose money. That means there’s no guarantee that you won’t lose money during that reset period. For example, you would have lost money last year if, in January 2022, you started following the strategy used in the Edesess/Huebscher simulation, since both are two-year corporate bonds. And S&P 500 two years
SPX,
call options reduced. But at least by the end of the year, you’ll be healthy again — and profitable if the stock market rises above early 2022 levels.
If two years is too long for you to wait to heal, you should choose shorter-term bonds and options. As a general rule, your upside potential will be smaller with shorter maturities/terms. That’s just another way of saying there’s no free lunch: If you want higher profit potential, you need to take more risk.
This helps us understand the big loss last year of a mutual fund pursuing this bond plus call strategy. On the other hand, its loss might lead you to see it as a reason to avoid all strategy variations, although that’s not a fair assessment. I’m referring to Amplify BlackSwan Treasury and Growth Core ETF
SWAN,
lose 27.8% in 2022. The reason for the large loss is that some of the treasury bonds the fund owns are long-term, which means the fund has a similar risk/reward profile to the FIA with a time horizon. much longer reset time.
Different ways to pursue a bond plus call strategy
But you don’t have to focus on long-term bonds to pursue this strategy. Zvi Bodie, who spent 43 years as a professor of finance at Boston University and who has spent most of her career researching issues of retirement finance, said in an interview that there is a There are a number of factors to keep in mind when choosing which variation makes the most sense. . Including:
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The amount of time that you’re willing to lose money in the process, even if you eventually make it all back. Over that shorter time horizon, you’ll want to choose shorter-term bonds and call options with closer maturities. Bodie points out that you don’t need to follow the same reset period every time you execute a strategy. For example, if you are particularly risk-averse today, you can choose a one-year reset period; a year from now, if you feel more aggressive, you can choose a two or three year reset period.
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Your credit risk tolerance. If you are particularly risk-averse, you may want to choose Treasuries for the bond portion of this strategy. If you’re willing to take on more credit risk, you can use high-grade corporate bonds instead, or if you’re even more aggressive, lower-grade bonds.
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The shape of the yield curve. If the curve is flat or inverted, you can secure a higher participation rate even if you focus on bonds with shorter maturities and call options with shorter maturities. For example, with today’s inverted yield curve, a 1-year Treasury note yields a 2-year Treasury bond yield (5.06% vs 4.89%). So by building a bond plus call strategy with a one-year reset period, you can guarantee a higher participation rate next year than the two-year term. But, Bodie reminds us, there is a reinvestment risk later in the year; If the rate is much lower than it is now, the effective participation rate for next year will be lower if you choose a two-year reset period today.
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TIPS versus Treasury or corporate bonds. Bodie said there may be circumstances when TIPS—Treasury Inflation Protected Securities—would be more appropriate than a regular Treasury or corporate bond for the bond portion of a plus-bond strategy. with your right to buy.
Regardless of the particular variant of the bond plus call strategy you pursue, you need to roll it over as the bond and options mature and expire. That means on that due date/expiry date you will need to pay close attention to the various factors that Bodie mentioned. But it doesn’t have to be that difficult: Even if the reset period is as short as a year, that means, for 12 months of interlacing, you can safely ignore market fluctuations.
Despite that, it’s never a bad idea to consult with a qualified financial planner. Good luck!
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]
