Index Notes, for the Conservative Among You

Index notes are a way for risk-averse folks to participate in the stock market without losing the farm.
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Maybe you've heard the pitch from your broker, brother or racquetball buddy. "Get upside performance that mirrors the

S&P 500

with zero downside risk -- all in one compact little package known as an index note." For those of us still sober enough to stand after the intoxicating effects of a decade-long bull market binge, the proposition seems just too good to be true.

Recent experience notwithstanding, markets don't always go up, and basic economic forces ensure that every potential reward is offset by corresponding risks. In other words, the bigger the buzz, the bigger the hangover you're risking -- at least in the long run.

So what's going on when the odds are seemingly stacked in your favor? Have the backroom quant jocks finally discovered financial cold fusion? Or are index notes just a hasty amalgamation of common household financial instruments cobbled together and marketed under the guise of a better mousetrap?

The Basic Scoop

"Index notes have been around for a very long time," according to my contact at a major I-bank that manufactures these paper paradoxes for public consumption. How long is a long time? "The first ones started popping up way back in the early '90s," he went on to say. (I guess the current spate of market myopia has penetrated even the upper echelon of professional investing these days.)

In its simplest form, an index note takes the shape of a 5- to 7-year "bond." The notes are purchased at par value in retail bite-sized chunks of $10 per unit and pay no actual interest. Upon maturity, the notes are redeemed by the issuer at the greater of (1) the original par value of $10 each, or (2) $10 plus the percent price increase of the underlying index since the date of issue.

For example, say I buy a 5-year index note on Jan. 1, 2000, for $10. Let's also say that this particular note derives its value from the hypothetical Ticket to Hell index of 30 leading arms makers, distilleries, casinos, adult publishers, and tobacco growers, which happens to be trading at exactly 666.

During the 5-year hold, I derive no value from the note, much as if I had purchased a nondividend paying stock. Come Jan. 1, 2005, however, I'm assured of getting at least my ten bucks back from the issuer, even if the index takes a 40% dive to 400 on a collective surge of moral righteousness. If, on the other hand, our national propensity to party continues unimpeded, my return matches the index's percentage gain point for point. For example, if the index is trading at 1,000 on New Year's Day 2005, I get $15 per unit (a 50% gain on the index = a 50% gain on my investment).

Recently, index notes have been introduced with a variety of bells and whistles, including call provisions and more liberal downside risk limits on the order of 10% instead of zero. Generally, though, the proposition is the same. Limited downside risk, high upside potential.

In theory, you could replicate the behavior of index notes by buying all of the stocks in a given index and then purchasing protective puts using the dividend stream from the underlying stocks to pay the option premiums. In reality, though, assembling and paying for all of the various components would be a huge hassle -- if not downright impossible for the average retail investor. From that sense, small investors may be better off letting firms like

Merrill Lynch, Morgan Stanley

, and

Solomon Smith Barney

package the instruments up and sell them in easily digestible morsels.

The Caveats

Before you go stocking up on index notes like cases of fruit cocktail on the eve of Y2K, however, you should be aware of some of their unique features:

Phantom Income: I'm not talking Darth Maul here, but rather an equally terrifying menace -- the IRS. Even though index notes pay no actual interest during their lifetime, the government treats them like they do -- and taxes you at the ordinary income rate for cash you've never seen. As a result, you'd be well advised to keep your index notes in tax-advantaged accounts like IRAs to avoid a phantom tax hit.

Liquidity: Although the issuers claim that a relatively active secondary market exists for the notes, you can almost count on taking a haircut if you try to sell your investment prior to maturity. If you buy, plan on holding for the full term to reap the full benefits of the notes.

Opportunity Cost: While a guarantee of getting your full face value back upon maturity may seem like zero downside risk, you should think about the amount of money that you could have received by investing in a corporate or government bond for the same term. A 4% zero-coupon Treasury note guaranteed by the U.S. Government would yield about $13 over seven years. As such, you could make the argument that any return on your index note below $13 represents a loss -- essentially the risk you take for enjoying the index's upside potential.

In general, since each note is structured differently, and may contain more risk factors and features than detailed in this brief overview, be sure to read the prospectus carefully before buying index notes for your own portfolio.

So while index notes don't represent some kind of life-altering quantum leap in financial theory, they may be a convenient way for risk-averse folks to participate in the stock market without losing the farm. As long as you understand the quirky aspects of these young pups before bringing them home to stay, I can think of worse investments for a conservative long-term investor to make.

Andrew Greta is a project manager for