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Author: goodald Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35387  
Subject: Market Index Certificates - Opinion? Date: 11/18/2003 3:01 PM
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I have a 'largish' amount of cash sitting around earning 2% in my ingdirect account. This is in addition to my emergency funds and I feel confident that this additional amount will not be needed anytime in the next 2 years. After this time I will probably want to use this, and some additional cash I would have saved, as a downpayment on a mortgage. In looking at various alternatives for the investment (I bonds/kept in savings etc..) I came across an investment that my bank offers that I am not too familiar with but may be worthwhile.

As a riskier option my bank offers a Market Index Certificate.
From the date you invest the funds (1,2,3,5,7 year increments) at the maturity date the values are compared. If the index has gone up I earn dividends equal to a percentage (called participation percentage) of the increase. If it has gone down or stayed the same I earn nothing but do not lose any of the initial deposit.

In the example they provide:
Purchase a certificate when S&P is at 600. Two years later it matures and the S&P is at 720, a 20% increase. Multiply that value by 75% (participation percentage) to obtain earnings rate. In this example 15% is earned (7.5% per annum)..



There are some drawbacks-
>the sell date is out of my control (always at the 1,2,3 etc.... year increment..
>The participation percentage eats into potential gains.. I'm also guessing the earnings would be taxed at normal income rate...


I'm not exactly sure what the participation percentage may be other than the example they give-I'm guessing it may be lower on a 1 year and higher on a 5 year. The fact that you will not lose any principal is a plus... Perhaps buying 4 500 dollar certificates spread out over 4 months? At most I would lose out on about 80 dollars in interest I would have earned had it stayed with ING... (a bit more with bonds)

Just looking for some input-especially from anyone who has experience with this product. Thanks! :)

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Author: Foolferlove Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 8879 of 35387
Subject: Re: Market Index Certificates - Opinion? Date: 11/18/2003 3:44 PM
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Just looking for some input-especially from anyone who has experience with this product. Thanks! :)

For 99.9% of people, this sort of arrangement is not a good idea. Folks should identify an asset allocation and decide what they need in bonds, stocks, cash, etc.

But for some folks like you who have a chunk of money that they need in the short term, 1-3 years, this kind of an investment is a judgement call. It's basically a gamble on the prediction of the market. And I think you've got a good handle on what the issues are. (Just make sure you read the fine print!)

Let's say you have $100,000 you want to use in 2 years to buy a house. You can keep at ING and get $2,000 a year for 2 years and end up with $4,000, risk-free (assuming interest rates stay relatively constant).

Or you can put that $100,000 into the Market Index Certificate. On the down side, you don't lose any money, but you lose $4,000 relative to ING. On the upside, you can make 75% of the SP500. In order to come out even vs. ING the SP 500 would have to increase about 5.3% to earn you a 4% return after two years (ignoring the effect of any compounding after one year).

So the choice comes down to whether you want to make a $4000 bet on whether the SP500 will be up over 5% from where it is today.

Or in your case, an $80 bet. I don't really have an opinion on whether this is a good idea or not. My LONG term money is on the fact that the SP500 seems very expensive on a historical basis and is not likely to go up much at all in the next 5-15 years. In the short term, ANYTHING can happen.

So go ahead and roll the dice!

On the other hand, you can stick with ING and collect your $80.

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Author: yobria Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 8880 of 35387
Subject: Re: Market Index Certificates - Opinion? Date: 11/18/2003 10:25 PM
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There are insurance products similar to this- the gains on your cash value is tied to an index * the participation percent.

Essentially you're hedging your investment, which you could also do with options, shorts, etc.

Seems like a reasonable option in your case, but it's less attractive if you can't get the cap gains tax rate. Why not buy ING stock instead...it's paying 4.64%!

Nick

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 8881 of 35387
Subject: Re: Market Index Certificates - Opinion? Date: 11/19/2003 8:41 AM
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"Why not buy ING stock instead...it's paying 4.64%!"

Because putting money for a downpayment on a house on a stock, any stock, is too risky. Putting money needed in a couple of years for anything on a stock is too risky. I know Ing is this wonderful institution that is doing glorius things and can't possibly be a risk, but things do happen. For example, when Fed rates go up, bank stocks historically have gone down, because they can't squeeze as much from the free money. And, it could well be that other banks will soon join the on-line discount business en masse, squeezing Ing.


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Author: yobria Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 8883 of 35387
Subject: Re: Market Index Certificates - Opinion? Date: 11/19/2003 10:57 AM
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>>Because putting money for a downpayment on a house on a stock, any stock, is too risky

Yes, my remark wasn't meant to be serious financial advice. Just neat that the div is so juicy right now.

Nick

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Author: goodald Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 8884 of 35387
Subject: Re: Market Index Certificates - Opinion? Date: 11/19/2003 11:01 AM
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Thanks for all the feedback everyone! Definately given me something to think about. Once I get some more details on how the gains (if any) are taxed and participation percentage is calculated i'll make my decision.

The comment that the s&p is expensive by historical standards, and thus may have limited growth potential over the next decade or so, is also an important point to remember. Thanks again!





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Author: galagan Big gold star, 5000 posts CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 8885 of 35387
Subject: Re: Market Index Certificates - Opinion? Date: 11/19/2003 12:46 PM
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These instruments are hybrid securities, composed partly of zero-coupon bonds and partly of LEAP options on whatever the benchmark index is.

The zero-coupon bonds guarantee your principal even if the index goes down. The option gives you participation in the index if it goes up.

If you want to do this, it's almost always better to put together the transaction yourself. Then you (1) understand it and (2) have total control over it.

An example: If you have $20,000 to invest for 2 years, then you can get a Treasury zero-coupon bond for about $19,000. You can take the remaining $1,000 and buy a Dec 2005 LEAP call on the LSX index (S&P 500 divided by 10) with a strike of 105. If the market stays where it is, you'll get your $20,000 back. If the S&P goes from 1050 to 1100, your option will be worth $500, so you'll make $20,500 - a 2.5% gain with the market up 5%. If S&P goes to 1300 (about 11% annualized), then your option will be worth $2,500, so you'll make $22,500, which is about 6% annualized. So it looks like the participation rate is about 50%.

If you use corporate zeros instead of Treasuries, your participation will be better. If you use longer-term zeros, you'll have more participation because the longer rates make the zeros cheaper.

==
If it's too hard to understand, then the likelihood is that it's a good deal for whoever's selling it to you and not necessarily a great deal for you. Be careful.

dan

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