Fixed index annuities are not the only way you can invest in the stock market and be assured of not losing money over the short term.
That’s because there’s a do-it-yourself alternative that avoids the high commissions associated with fixed index annuities (FIA). And it’s not particularly onerous.
I’m focusing on this do-it-yourself alternative as a follow-up to last week’s column on strategies for immunizing your equity portfolio from losses. As you may recall, in that column I mentioned a specific FIA that, in addition to guaranteeing that you will not lose money over a 12-month period, pays you 55% of the stock market’s gain when it rises. In return, you forfeit all dividends as well as 45% of the stock market’s gain.
Several readers emailed me to say they didn’t think this was a good deal. They argued that giving up nearly half the stock market’s upside and all dividends is too high a price for not losing money over any 12-month period.
My response to these readers: It is possible to secure a higher participation rate by investing the bulk of your equity portfolio in bonds and using the small remainder to purchase in-the-money index call options that expire at the same time the bonds mature. You are guaranteed not to lose money over the period between when you initiate the trade and the date on which the bonds mature and options expire.
To appreciate the promise of this approach, consider a simulation conducted several years ago by Michael Edesess (an adjunct professor at the Hong Kong University of Science and Technology) and Robert Huebscher (founder of the Advisor Perspectives website). They assumed that their hypothetical portfolio, every two years, invested 93.7% in high-quality corporate bonds maturing in two years’ time and 6.3% in a two-year in-the-month call option on the S&P 500. Assuming the then-prevailing two-year corporate bond rate (3.3%), and assuming the S&P 500 would produce an 8% annualized rate, this bonds-plus-options strategy produced a 5.4% annualized return over a simulated 12-year period.
Note carefully that the maturity of the bonds and options expiration you choose is the equivalent of the “reset period” over which FIAs guarantee that you will not lose money. That means there’s no assurance that you won’t lose money along the way during that reset period. For example, you’d have lost money last year had you, in January 2022, started following the strategy used in the Edesess/ Huebscher simulation, since both two-year corporate bonds and the two-year S&P 500
call option fell. But by the end of this year you will, at a minimum, be whole again—and sitting on a nice gain if the stock market rises above its beginning-of-2022 level.
If two years is too long of a period for you to wait to be made whole again, then you should pick shorter-term bonds and options. As a general rule, your upside potential will be smaller with shorter-term maturities/expirations. That’s just another way of saying that there is no free lunch: If you want greater profit potential you need to incur more risk.
This helps us to understand the big loss last year of a mutual fund that pursues this bonds-plus-calls strategy. Its loss might otherwise strike you as a reason to avoid all variants of the strategy, though that’s not a fair assessment. I’m referring to the Amplify BlackSwan Growth & Treasury Core ETF
which lost 27.8% in 2022. The reason for its big loss was that some of the Treasury bonds the fund owned were long-term, which means that the fund had a similar risk/reward profile as an FIA with a much longer reset period.
The various ways of pursuing a bonds-plus-calls strategy
But you don’t have to focus on longer-term bonds to pursue this strategy. Zvi Bodie, who for 43 years was a finance professor at Boston University and who has devoted much of his career to researching issues in retirement finance, said in an interview that there are several factors to keep in mind in choosing which variant makes the most sense. These include:
- The length of the period over which you’re willing to lose money along the way, even if you’re made whole again by the end. To the extent that period is shorter, you will want to choose shorter-term bonds and call options with nearer expirations. Bodie points out that you don’t have to stick with the same reset period each time you roll over the strategy. If you’re particularly risk averse today, for example, you might choose a one-year reset period; a year from now, if you’re feeling more aggressive, you could choose a two- or three-year reset period.
- Your tolerance for credit risk. If you’re particularly risk averse you may want to choose Treasurys for the bond portion of this strategy. If you’re willing to incur more credit risk you could instead use high-grade corporate bonds, or if you’re even more aggressive, lower-grade bonds.
- The shape of the yield curve. If the curve is flat or inverted, you can secure a higher participation rate even when focusing on shorter-maturity bonds and call options with shorter expirations. With today’s inverted yield curve, for example, 1-year Treasurys are yielding more than 2-year Treasurys (5.06% versus 4.89%). So by constructing a bonds-plus-calls strategy with a one-year reset period, you can secure a higher participation rate over the next year than with a two-year period. But, Bodie reminds us, there is reinvestment risk at the end of this year; if rates are much lower then than now, the effective participation rate for the subsequent year will be lower than if you today choose a two-year reset period.
- TIPS versus Treasurys or corporate bonds. Bodie says there may be occasions when TIPS—the Treasurys Inflation Protected Securities—will be preferable to regular Treasurys or corporates for the bond portion of your bonds-plus-calls strategy.
Regardless of the particular variant of the bonds-plus-calls strategy you pursue, you need to roll it over when the bonds and options mature and expire. That means you will need to be paying close attention, on that maturity/expiration date, to the various factors Bodie mentions. But that doesn’t have to be onerous: Even as short a reset period as one year means that, for the intervening 12 months, you can safely ignore the market’s gyrations.
Regardless, 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]