Friday, July 06, 2007

Equity Linked Note Problems

One of the fads in the current market are Equity-Linked Notes (ELN's). These securities provide investors with fixed income-like principal protection together with equity market upside exposure. According to Lehman Brothers, the "instrument is appropriate for conservative equity investors or fixed income investors who desire equity exposure with controlled risk." They also state that the "the structure generally provides 100% principal protection. The coupon or final payment at maturity is determined by the appreciation of the underlying equity."

These are sold on the basis of buying them and forgetting them, without regard to market valuation. We think there are significant risks with this position:

1. Compounding and opportunity cost. We have previously discussed the idea that if you have a goal of earning 12% per year for 3 years and you actually lose 12% the first year it will require a return of 26.4% for each of the remaining 2 years to reach the 12% annual goal. A 12% return is a doable objective; a 26.4% return is considerably more challenging. In the case of the equity-linked notes, just because you avoided the 12% drawdown does not mean your investment is "flat". The reality is that if the underlying index declined 12%, you will need it to rise back to the starting level before you will be able to earn any positive return. In addition, the underlying index will still need to return 26.5% in each of the final 2 years to realize a 12% annual return over 3 years. If an investor had a better sense of when the values were advantageous and invested accordingly, the returns would improve despite the marketing pitch that ELN's represent a free lunch. During the initial period when the ELN index is declining and then rebounding back to break-even, the opportunity cost of not being invested in an investment that is rising is a significant detractor to long-term returns.

2. Buy and forget. At the other end of the spectrum is the case of purchasing an ELN and then experiencing good returns in the early years. These are sold on the basis that the principal is assured so they can be tucked away and forgotten about. But if the ELN rises, say 20% in the first year you now no longer are in a position that the principal is assured. Why? Because a decline the following year will wipe out the gains. Effectively we are marking-to-market the principal value. As such, gains are not locked in and an investor is never in a position to walk away and forget the investment.

Bottom line: losses early cause the investment to potentially be "dead money" for an extended period of time. Gains early still require a decision about whether or not to continue to hold. Perhaps the investors that should consider ELN's are those that have no inclination or interest in analyzing value in the marketplace or investors who have found themselves chasing markets in the past and need an investment to save them from themselves (buying an overvalued ELN and having a flat return over a period of years is preferable to buying high and selling low).

Strategy Update: Performance for the first 6 months will be available soon at the Wind River Advisors website. The best performing strategy continues to be Focused 13D, up +27.6% year-to-date, followed by Select Equity up +16.0% YTD versus the S&P up 6.9%. We're also particularly pleased by the Dynamic Bond/FX Strategy up 11.8% YTD versus the Lehman Aggregate Bond Index up less than 1% YTD. Performance was driven by tactical weighting of bonds (long or short) and the US dollar (long or short). Please note that past performance is no guarantee of future performance. See the performance PDF for the full disclosure.


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