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An "enhanced yield"?–not

Chris Farrell Jan 13, 2009

Question: Hi Chris – My husband was given a brochure regarding something called the Capital Protected Fixed Yield Enhancement. Apparently this type of investment was only available to large institutions in the past, but due to “technological advances” is now available to individual investors. I understand the basic principle but there are a lot of words in the brochure that concern me, like “hedged with offsetting positions”, “no risk or market exposure” and “fixed swap rate arbitrage”. I have never heard of this type of investment before and am wondering, if it is such a great thing why isn’t everyone talking about it, including my financial advisor? What are your thoughts Chris? In what type of scenario might an individual investor consider this type of investment? Thanks, Leslie, North Branch, MN

Answer: I can’t imagine any scenario where the average family would consider this kind of investment for their savings. The reason why many financial advisors aren’t talking about it is they are wary–with good reason. These are “black box” investments with lots of moving parts that don’t pass the “easy to understand” test. What’s more, lots of supposedly “safe” hedging strategies involving derivatives have blown up over the past two years. They tend to be high fee products.

Briefly, there are a number of capital-preservation enhanced-yield type products on the market. Typically, it involves investing money in a fixed income security at home or abroad. You get your principal back at the end of the investment from the income generated by that fixed income investment. The interest income allows the financier to take a sliver of your money upfront and place it in a basket of equities, foreign exchange rates, commodities, or some other investment. The game is to goose your yield by using derivatives, such as options, futures, swaps, swaptions and the like to create the opportunity of earning a higher return. Confused? Wary? Good.

I’m concerned about a proliferation of savings vehicles with bells and whistles designed to take advantage of our desire to save and yet earn a better yield than we can in Treasury bills, FDIC insured savings accounts and certificates of deposit, Treasury Inflation Protected Securities, I-bonds, and other investments backed by the full faith and credit of the federal government. Well, I like the government’s handshake. I like the simplicity of the investments. The trade-off of a lower return is just fine with me.

The bottom line: Let the institutuions play with investment startegies like this. But for those of us working hard with for our money and trying to save against a rainy day, I’d steer clear of all enhanced- products unless you have a clear understanding of how they work, the risks you’re taking, the reason you’re taking on that risk, and a good understanding of how it will affect you if the deal goes bad. Think I’m kidding? Just talk to someone who put their savings into supposedly super-safe auction rate preferred several years ago. With the credit crunch, many of those investors still don’t have access to their money.

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