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Indexing without mutual funds

Updated: May 3, 2013 12:14PM



Originally published: August 1, 2007

In the last few weeks, this column has focused on the concept of indexing - tying investment performance to a market index, instead of trying to ``beat’’ the market by using timing, investment research or reading tea leaves to do better than the market as a whole. The simplest way to participate in this strategy is to buy index mutual funds either in your own name or in an individual retirement account.

But many other investment concepts use indexing. Some are good deals, while others are not worth the cost or risks. So don’t just jump at the word ``index’’ before you carefully examine the additional fees and restrictions on these products.

Indexed Annuities: Annuities are insurance company products that allow your cash to grow tax deferred - either at a fixed rate of interest, or in a variable mutual fund type of investment. In return for the promise of tax-deferred growth, you’ll have to pay higher annual fees of about 1.5 percent above the management fees for the underlying fund. You’ll also face some restrictions on your ability to withdraw your cash. Earnings withdrawn before age 59 1/2 face a 10 percent federal tax penalty, as with most retirement-type accounts.

And all annuity products have surrender fees, which typically decline to zero over a period of five to 10 years. But there’s no restriction on the amount of cash you can invest in these tax-deferred annuities, as there is with retirement accounts such as 40l(k) plans and IRAs.

Withdrawals of earnings are taxed as ordinary income.

Variable annuities typically offer a choice of mutual funds, called ``separate accounts.’’ The value of your annuity grows based on the investment performance of the funds you choose within the annuity contract. Most insurance company contracts do offer a choice of index funds inside the annuity contract. If you believe in the concept of indexing, using an index fund inside an annuity makes sense.

In fact, Vanguard Group has partnered with an insurance company that markets these index-based variable annuities with very low annual fees (800-522-5555). The value of your contract depends on the action in the market, but a portion of your fee goes to guarantee a death benefit so that when you die your investment can never be worth less than the amount you originally put into the contract.

In fact, some annuity contracts actually ``lock in’’ the death benefit at a higher level each year, depending on the performance of your investment. Of course, if you need to withdraw cash before you die, there is no guarantee that the account might not be worth less than your original investment if the market has taken a drop.

Now, here’s a warning. Make sure your annuity offers you the opportunity to switch out of the index fund to a safer fund, such as a money market fund if you’re worried about the stock market. Of course, you’ll be paying a lot of annuity fees to get low money market rates, but at least you’ll have some downside protection.

Some insurance companies only offer a ``point-to-point’’ annuity that is based on the performance of the S&P 500 index. The investment portion starts with the value of the S&P 500 index on the day you open your account. Then, at a given date in the future - typically from five to 10 years - they promise your account will be credited with the value of the S&P index on that date. If the market happens to be in a slump at that point, you will forfeit all previous gains from the interim period.

Index-based CDs: Various financial institutions offer a different twist on indexing - tying the return on a CD to the performance of the S&P 500 stock index. Bankers Trust even offers indexed CDs tied to their foreign market indexes, including the EAFE International Index, the Euro 100 index, and the Nikkei 225 Index.

These CDs guarantee your principal at 100 percent - if you leave the money in the CD for a specified time period, typically five to 10 years. If the market goes up, you receive the full percentage increase - at the date on which the CD matures. And that’s the rub.

If the market has been higher, but happens to fall when your CD matures, you’re out of luck, and out of returns.

Typically, the institution hedges its bets by using zero coupon bonds and futures markets to offset the risk in making this promise.

There is an opportunity to liquidate your CD prior to maturity so you can lock in any gains, but your profits will be discounted by the firm’s cost of liquidating the hedge, another market risk. And, if you want to get out of your CD because the index is dropping and you fear it will fall further, you could take a loss of principal unless you hold the CD to maturity.

There’s one other drawback to most indexed CDs: The index does not give you the dividend return of the stocks in the index.

Currently, that’s a paltry 1.3 percent, but in past years dividends have made up a significant portion of the return on stock investments. And unlike actual stock investments, the gains on these CDs are considered ordinary income instead of capital gains. But the CD itself is FDIC insured.

Tying your investment to a foreign index involves a different degree of market risk. These indexes have been around for eight years, says Alex Green of International Assets Advisory (800-432-0000), which markets foreign-index CDs for Bankers Trust. He notes the CDs have been wildly profitable for original investors who purchased CDs linked to the S&P 500. Those who bought the Nikkei 225 CDs at least got their principal back, although that market is well below levels of eight years ago.

Index trusts: Here’s an unusual twist on indexing. Various brokerage firms have offered a fixed-income security that trades on one of the major exchanges, much as a closed-end mutual fund. Since they are priced throughout the day, you can trade them easily. The security itself has an initial offering price, and its value is tied to the performance of an index such as the S&P 500 or the Nikkei 225 index. At maturity, typically in five years, the owner receives the guaranteed face amount, plus any appreciation in the index, as specified in the original offering. In the meantime, these securities trade on a daily basis and are valued based on the current level of the index.

Among the most popular of these securities are the Merrill Lynch MITTS, which stands for market index target term securities. For tax considerations, they should be purchased only in tax-sheltered retirement accounts where accrued, but unpaid interest, will not be taxed. These securities offer the upside potential of the market index to which they are tied, with a guaranteed return of principal at a given date. As such, they let investors minimize stock market risk.

Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil Co. You can send her questions via e-mail at savage@suntimes.com. Her second book, published by HarperCollins, is Terry Savage’s New Money Strategies for the ‘90s. Copyright Terry Savage Productions.



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