Money for Nothing, No-Risk for Free?

What if there was an investment that had no downside, but only upside? Gain, without the pain. The Holy Grail of assets! Sounds too good to be true? Well, it may or may not be, depending on your point of view. But before you can decide for yourself, let us look at what we mean by some of these terms, and try to quantify them. Then we will look at a class of investments that aim to conjure up such returns and subsequently analyze whether or not they maybe suitable for your portfolio.


To gain or not to lose?
What is a financial gain or loss? In most cases, it is easy to determine this. Let us say you invested $100, and you got back $110 (or $90) in 1 year. You gained 10% (or lost 10%). So far so good. But was this a “good” investment? Or, if you made 10% and the average investor made 20%, did you really “make money”? To answer these you need to compare your returns against an appropriate “benchmark”. How does one select a benchmark? It could be one of the many financial indices, or your neighbor. Now it gets interesting. Say, the benchmark returned 15% (or lost 5%) in this case. Then your investment did not beat the benchmark. Maybe it was not a good idea to buy that $100 slow-scratch ticket. Put another way, if your investment underperformed against the benchmark, would you consider it to have made a “loss”, even if you had a positive return? Subjective and debatable. For now, let us say yes, and call this a “notional loss”. But think about this one. There will be a quiz.


The MarketSafe CDs (http://www.everbank.com/canvas.asp?id=9112&IdPage= pro_mscd_hypo_1) from EverBank.com are examples of investments in this class. The hypothetical returns for the past 10 years for one such CD are shown below.

(CD used in this analysis http://www.everbank.com/direct.asp?idpage=pro_mscd_termJ)





It has a return “linked” to the S&P 500 index (one of the most widely used financial benchmarks), but guarantees a minimum total return of principal + 5% even if the index has a sub-zero return. Newer MarketSafe CDs follow a similar linking to an index, but the terms and calculations vary. For example their latest offering is linked to the Spot Price of Gold, but guarantees the principal if held till maturity.


No pain, just gain!
No downside, only upside! Yes! But that’s not enough. To understand if this is a “good” investment, we also need to determine its total return in various market scenarios. The broad market could go up steadily, go down, go up then down, do a snakes and ladders… you get the drift. What will this CD return? What are the “characteristics” of this investment? To figure this out, we first reverse-engineer the hypothetical sample data given by the bank to arrive at an empirical formula for its return. To keep things simple, I will not delve into the details, but gladly share the spreadsheets with the curious. The formula in semi mathematical terms is (excluding the principal)

MS CD 5 year return = Maximum of 5%, or, (Average of (10 semi annual values of the S&P index) / initial value of the S&P index) -1

Note the “Average” in this formula. That’s what lops off your upside vs. the index. To get a flavor of how it does this, consider the S&P going from 1000 to 1200 in one year. The S&P return is (1200-1000)/1000 = 20%. The “average…” calculation above would give ((1200+1000)/2 / 1000)-1 = 10%. So the CD returns roughly half the S&P index return on the upside.


Armed with this formula, we can now calculate the return for different scenarios, from the simple (almost linear growth) to the more complex (snakes and ladders with differing percentage changes). A relatively simple scenario, let us call it “spook the market”, is to assume that the S&P index will go up for ‘n’ semi-annual periods, then decline for the remaining duration of the CD. I chose semi-annual periods to tie-in with the semi-annual S&P values used in the CD’s calculation. Also assume that the percentage change in each period is the same, whether up or down (5% in this case). This scenario’s returns are shown below.





The chart shows the return of the MS-CD (red), the S&P index (green) and the difference of the CD over the index (blue). Notice that the X axis is the number of semi-annual periods after which the index starts to decline. So, 3 periods is 1.5 years out from the initial pricing date of the CD (Jan 2006). For the folks familiar with financial options, the “CD Return” above is like a Long Call Option, albeit with no downside!


Devil in the details?
Now you can observe a couple of non-obvious characteristics of this investment. If the market starts to tank within 5 periods, you make the guaranteed minimum, instead of a loss. The difference over the S&P return is also the maximum in this case. If the decline starts after 5 periods, but before 9 periods, your return starts increasing, and is still more than the S&P return. When the S&P decline starts in the 9th period or later (or there is no decline), the CD returns about half the return of the S&P, but both are positive returns.

Why are the characteristics (“returns profile”) important? Because, even though you could make an educated guess about the markets direction, you cannot predict where it will go (else you would be very rich). Even by cherry picking a point on the chart above, which “freezes” the S&P inflexion point, you still are at the mercy of the percentages, which will pinpoint your actual return on the Y axis. Maybe it is just me, but there is certainly something Heisenberg-like about this concept. Hence it is worthwhile to look at the behavior of the investment in a few scenarios. The calculations above are for a few of the many possible market situations, each with different probabilities of occurrence. More complex scenarios can be similarly played out in the spreadsheet, by varying the percentages, the ups and downs, probabilistic scatter plots and getting into Monte Carlo Simulations. Such sophisticated analysis could give an even better picture of the investment, but that would be overkill here.


Huh?
What does all this mean for you, the investor? This CD should not replace your bank account, simply because the money is locked for 5 years, and an early withdrawal is not guaranteed to get the principal back. However, this is a good investment for those conservative investors who are willing to forgo some gains in return for downside protection. Think of the extra gain you could have made as the “safety premium”. It is like life insurance, but only better. More sophisticated investors could leverage the option like characteristics of the CD to craft better investing strategies, or hedge their other bets.

Another way of looking at it is based on where you think the market is headed. If you feel the S&P will continue to go up, but then decline within the CD’s duration, then the chart above will give you the probable returns profile. Your actual return will depend on how long the market goes up/down and by how much. It seems that the “best upside” (without “losing” relative to the index) is when the market heads south between 2.5 to 4.5 years from Jan 2006. But, if you think the market will only go up, and don’t like leaving even a cent on the table, even if you could lose a few cents on the downside, then you may not like the idea of the CD company (“counterparty”) pocketing “your gains” in this apparently zero-sum game. Go with the index instead. This CD is not for you if you couldn’t take a “notional loss”.

But that begs the question: if you aren’t what you could be, are you a “notional loser”? But that’s another story.