Skip to main content

I was wandering through the American Stock Exchange Web site doing some research into HOLDRs and Spiders (S&P Depositary Recipts) (SPY) - Get SPDR S&P 500 ETF Trust Report and ran across something called MITTS. The short descriptions are that they are principal-protected securities and there is always a formula included to calculate their value. They also apparently trade like regular securities. Can you provide some commentary on these things? -- David Miller

David,

Some financial products can sound very simple but turn out to be complicated.

Meet the MITTS.

MITTS, a

Merrill Lynch

creation, are market index target-term securities. Other big brokerage firms, including

Salomon Smith Barney

, have their own versions of the products just without that nifty acronym. They are broker-created and broker-sold inventions.

These securities, generically called equity-linked notes, are bonds linked to an index or a basket of stocks. They're designed to limit your downside risk but also deliver a certain amount of return tied to the performance of a group of stocks. They trade on exchanges like the

New York Stock Exchange

and the Amex.

In the past, Merrill has launched MITTS on the

S&P 500

, the

Russell 2000

TheStreet Recommends

, the

Nikkei 225

and even its own

Internet HOLDRs

(HHH)

basket. Salomon Smith Barney, as another example, has created equity-linked notes on the

Nasdaq 100

and the

TheStreet.com Internet Sector

index. (TheStreet.com Internet Sector index was created by

TheStreet.com

(TSCM)

, which publishes this site.)

The investment sounds like a no-brainer.

You're guaranteed to get your money back at maturity -- no matter what happens to the stock component of the security. If those stocks go higher, you get some of that upside return. In times of such volatility, these investments might look great. You can buy insurance on an investment that has a good chance of having a coronary.

However, these equity-linked notes aren't a simple proposition. They each have nuances and varying provisions that are not easy to understand. One is usually structured differently from the next. So investors without a deep knowledge of finance will have great difficulty calculating the actual value of this insurance they are buying.

"It's very difficult to know if you're getting a good deal in buying one," says Robert Gordon, head of

Twenty-First Securities

in New York.

In theory, investors could construct an equity-linked note themselves.

This structured product is basically a zero-coupon Treasury bond and a call option on an index or a basket of stocks. The zero-coupon Treasury is a risk-free bond that doesn't pay annual interest. A call option -- the right to buy a stock at a specified price up to a certain date -- gives you exposure to that index.

Say you've got $100. You take $75 of that and buy a bond with a face value of $100 that matures in five years. Then you take the remaining $25 and buy a call option on an index like the S&P 500 that has a five-year expiration. You have a risk-free investment and, hopefully, a little added return from the option.

However, many of these equity-linked notes mature in seven years from the date of issue, and you can't find an exchange-traded option with an expiration date greater than five years. As a practical matter, options don't really go out more than three years.

That's where the brokerage firms can add some value with these equity-linked notes.

In mid-1998, Merrill Lynch, for example, came out with

S&P 500 MITTS

(MLF)

that carried a seven-year maturity. They're easy enough to understand. You're guaranteed to get 100% of your principal back plus any percentage gain in the S&P minus a specific percentage every year (Merrill takes 1.3% every year.) At maturity, investors would get their principal back plus the performance of the S&P index minus about nine percentage points.

Yet, these products have become more complicated.

"You have to look at the details of each one," says Dick Mikaliunas, senior vice president of capital markets at the Amex. "There are so many different exceptions and different little twists."

Some common characteristics do exist: Most are issued at $10 a share and provide 100% principal protection. They are generally tied to the movement of a stock index.

With interest rates low and volatility high, the brokerage firms have had a more difficult time making these products attractive to investors. (The higher the volatility, the more expensive options become.) It's tougher for a firm to give an investor 100% of the upside of an index plus the principal protection in one of these notes. Instead, they've had to come up with new features to make them attractive and thereby saleable. (You can buy and sell these securities in the secondary market, although most individuals buy them on the offering.)

You'll find equity-linked notes like the one offered by Salomon Smith Barney one on TheStreet.com index that are callable, meaning they can be redeemed prior to maturity date. That product also only guarantees 90% of your principal back and caps the upside you can get to 25% a year.

Because these securities are very different from one another, the average investor won't easily be able to tell if the products are a good deal or not.

Of course, if this kind of downside guarantee gives you priceless piece of mind and keeps you in the market, then one of these notes may be worth it.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.