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Structured CDs: hedge of no return

Don TaylorQuestionDear Dr. Don,
In a recent column from Bette about structured certificates of deposit, your answer indicated they are less risky "without limiting upside potential." Can you name some of them?
-- Vladimir Volatility

AnswerDear Vladimir,
A structured CD derives its investment value based on the investment performance of some underlying asset. CDs that earn interest based on the performance of a stock index are one common example, but others include CDs based on interest rates, commodities, inflation and currencies. Many structured CDs have a call feature allowing them to be called, or paid off early, by the issuer.

My actual quote to Bette was, "There are less expensive ways to hedge downside risk without limiting upside potential." My point in the reply was that the structured CD investor pays the cost of the hedge in the form of lower returns on the CD.

The lower returns come about because the typical structured CD doesn't provide the investor with the dividend return on the underlying index. Returns also are capped when the market for that index is up, and the issuer's ability to call the CD typically takes away the punch bowl just when the party gets interesting.

The Standard & Poor's 500 Index as of Dec. 30, 2011, had a dividend yield of more than 2 percent. Giving up the 2 percent yield is one of the costs of investing in structured CDs versus investing in the S&P 500.

There also are some tax side effects I didn't discuss in the original reply. The yield paid on the structured CD is taxable in the year earned, but yields typically aren't paid out annually. Instead, the investor receives the interest income when the CD matures. The income is also taxable as ordinary income versus capital gains.

I left out a discussion of the alternatives in the original answer because they require a degree of financial knowledge that goes beyond the typical retail investor. One option is to invest in the stock market and then buy a protective "put option" on the position. A put option gives the holder the right to sell the security -- in this case, the value of a stock market index -- at a set price over a defined time period. If the market sells off, you're protected by being able to sell the index at the put's set price.

That put option, like the structured CD, also is expensive insurance. One way to manage the expense is to fund the put by selling a "call option" on the position. The income you receive from the call finances all or part of the put. Selling the call limits your upside but reduces the cost of the insurance provided by the protective put. A call option gives the owner the right to buy the security -- in this case, the value of a stock market index -- at a set price over a defined time period. Since you sold the call, if the market went up over the set price, you would have to deliver the index at that set price, effectively getting you out of your position and, by doing that, giving away the future upside potential of the index.

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Another option is to invest most of your money in plain vanilla CDs, and use a portion of your funds to buy call options on the stock market index. You're buying upside return with the calls, but your principal, other than what you spent on the call option, is protected.

The best option most likely is to own stocks outright in your portfolio disguised either as low-cost, indexed mutual funds or as exchange-traded funds, or ETFs. Balance the risk of the stock investments by holding a diversified portfolio that considers your attitude toward risk.

During the lost decade in stocks, considered to be 2000 through 2009, the S&P 500 index, with dividends reinvested, had an average return of negative 1.25 percent. While it's nothing to brag about, you can shoulder that kind of loss in your portfolio in exchange for retaining the upside and inflation hedge found in a diversified stock portfolio.

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