Seeking Principal Protection Plus Upside

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

Many investors I talk to are trying to reconcile two objectives:

 Not to lose further principal.
 Not to sell at the bottom or forfeit the chance to make up losses.

As to the potential for long-term gains, legendary investor Warren Buffett recently wrote that he is buying U.S. stocks. He says he doesn’t know when the market will recover, but he finds many good values at current prices. Warren Buffett, “Buy American. I Am.” (October 16, 2008) NYTimes.com. However, few have Buffett’s ability to lose tens of billions of dollars of net worth and remain among the richest individuals in the world. Hence, the desire to place a floor under what you can lose.

As to the risk of loss, I would note the following numbers, which represent the current level of a stock index (or exchange-traded fund based on an index) (as of market close November 20th) compared to its one year high closing level:
 Dow Jones Industrial Average: 7552.37 (down 45.47%).
 S&P 500 Index: 752.44 (down 50.61%).
 NASDAQ Index: 1316.12 (down 51.88%).
Emerging markets have been hit severely. “EEM,” which denominates an exchange traded fund (IShares MSCI Emerging Markets Index) is at 19.39 (down 64.13%). “EFA,” representing IShares MSCI Europe and Far East Index), is trading at 36.90 (down 56.4%). As to stocks, this year, you could run, but you could not hide. Moreover, we appear to heading into a prolonged worldwide recession.

In the next several articles, I will discuss several methods to protect principal (not necessarily including inflation adjustment) while preserving upside in stocks. Notably, none of these methods provide either perfect protection (such as could be provided by US Treasury Bills) nor maximum profit potential (such as could be obtained by purchasing naked out-of-the-money call options on US stocks).

Among the products we will discuss are the following:

1. Equity-linked CD’s. In this product, a bank promises you a minimum rate of return, or alternatively, a return geared to formula including a component of stock market performance, whichever is higher. Gains on such products are subject to current income taxation.
2. Equity linked annuities. In this form of annuity, you contract to receive a minimum guaranteed rate of return, or a return linked to the stock market, whichever is higher, with many possible variations and options. Annuities offer the additional feature, potentially, of deferred income taxation. The credit quality of the guarantor is a key consideration.
3. Hedge funds. Many hedge funds offer strategies designed to mitigate downside market risk, pursuing strategies of either partial or full market neutrality. These strategies may be more or less successful. Hedge funds are generally offered as private partnerships offered exclusively to “accredited investors.” The tax efficiency of hedge funds differs depending on the strategy and its execution.
4. Home-made strategies. These may involve purchase of UST zero coupon bonds or instruments expressing a bearish stock market view, in conjunction with other securities expressing a bullish view. The zero coupon bonds potentially create current taxable income (called “Original Issue Discount” income), even though the return is deferred.

Note: The author of this article is not a tax expert. This article does not purport to give the kind of specialized advice, customized to your situation, which could be offered by a qualified CPA or tax attorney.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Print this post