Stock Market Alternatives

If you're a sophisticated investor -- one who has defined an investment strategy and built a portfolio around that strategic core  --  you may be ready to consider some nonstock alternatives that will add diversification to your investment mix. Unlike stocks, which tend to rise and fall as a group, the performance of these alternative investments is not correlated to the performance of the stock market.

Equity-indexed annuities

Five years ago, few financial advisers would have recommended annuities as investment vehicles for growth. Today, however, there are some fascinating annuity products available that have been built for the investment market. The best of these annuities will give you an interest rate equal to or greater than what you can earn at a bank.

An annuity is a contract between an insurance company and an investor. Investors deposit their money with the insurance company, and interest on the money grows tax-deferred. The investors receive the principal and interest back through periodic payments determined by the annuity contract.

There are three basic types of annuities:

• The traditional fixed annuity usually guarantees a minimum interest rate and a minimum benefit. The emphasis is on safety of principal and stable investment returns. Fixed annuities are often purchased by retirees who want a steady, predictable income stream.
• With variable annuities, the investor can choose different types of investment options. There is no fixed interest rate; the growth of principal depends on the performance of investments. Investors gain the opportunity for more growth of their principal, but also run the risk of losing money if the investments do not perform well.
• The equity-indexed annuities came into the market just five or six years ago. In general terms, they offer a contract return that is the greater of a fixed rate (usually somewhere around 3 percent) or a return that is a certain percentage of a stock market index, such as the Standard & Poor's 500 index. If the index goes up, the investor has the potential for greater returns; if the index goes down, the investor at least receives the minimum guaranteed rate of return.

Contracts for equity-indexed annuities vary greatly, so before you purchase one it is essential to be clear on all the details. Terms can last from six to 10 years. Returns are credited at certain pre-determined points, such as once a year or once every five years. Some equity-indexed annuities also have cap rates, which is the maximum increase allowed each year.

The minimum rate of return on an equity-indexed annuity is called its floor. Most contracts today have floors of between three and three-and-a-half. The rate linked to the index is called the participation rate, and is determined as a percentage of the stock market index. Participation rates may vary each year, again, depending upon the terms of the contract.

Let's assume an investor buys an equity-indexed annuity for $100,000. We'll assume a steady participation rate of 75 percent, although these rates are likely to change each year.

• The first year of the annuity, the S&P 500 index rises 10 percent. With a participation rate of 75 percent, an investor could receive a 7.5 percent return on his investment.
• The next year the S&P index rises only 8 percent; in that case, the investor would receive a 6 percent return.
• The third year, the S&P index goes up only 3 percent. In that case, the participation rate for the annuity would be only 2.25 percent  -- but the investor has a floor of 3.25 percent, so that is the return that he would receive.
• The fourth year, the market really turns around and the S&P index shoots up to 20 percent. Without a cap the investor would be due a 15 percent return, but since the annuity has a cap of 12 percent that is the maximum he can receive.

Pros and cons

Equity-indexed annuities can be attractive for investors who want a guaranteed rate of return over a fairly long period of time, but who also want a higher return than that offered by bank CDs or who want an opportunity to participate in market gains. Unlike bank CDs, however, annuities are not guaranteed by the FDIC or the federal government.

One additional caveat: equity-based annuities are sophisticated products -- so sophisticated, in fact, that they lend themselves to abuse and misrepresentation.  Before you invest, make sure that you are dealing with somebody who really understands you as a client and who is familiar with all of the nuances of the annuity that you are considering.

Managed futures

The managed futures industry is made up of commodity trading advisers, or CTAs, who manage clients' money in the global futures market.

These days, CTAs trade in over 150 different markets throughout the world, including agricultural products, energy, metals, foreign currencies, and traditional commodities.

Managed futures have become more popular in the last few years because their performance is uncoupled from the performance of the stock market. According to the Chicago Board of Trade, in the years 1992 to 2001, bonds showed a slight (.13) correlation with stocks. Managed futures, on the other hand, showed a negative (-.08) correlation in performance during that same time.

In addition, today's CTAs are making decisions based on computer models of market and price trends instead of on instinct or intuition. In this way they have been able to construct products (managed future funds) that offer a more tolerable risk for a reasonably knowledgeable investor.

Finally, since they invest in different global markets, managed futures funds offer immediate portfolio diversification. This can help decrease your portfolio's overall volatility while providing potential for enhanced returns. For the optimum diversification, you should have at least 5 percent, but no more than 15 percent, of your total portfolio invested in managed futures.

Before investing in a managed futures fund, you should check its past performance against indexes such as the Barclay CTA index, the Managed Account Reports (MAR) index, and the Mount Lucas Management (MLM) index.

Look before you leap

Alternative investments such as equity-indexed annuities and market futures are not suitable for every investor. But for those who have laid the groundwork with a core portfolio, putting just 10 percent of their money into an investment that is not correlated with the stock market has been shown to improve average performance numbers significantly over the long term.

If these alternatives appear attractive to you, talk with a financial adviser to find out more. Above all, make sure you understand all the potential risks and rewards before you make any investment decisions.

Trevor 'Chip' Lewis, Jr., CFP is Managing Director of PSA Financial Center, Inc. in Lutherville, Md. He was designated one of the Top 250 Financial Planners in Worth Magazine in 2001, and the Top 150 Best Financial Advisers for Physicians in Medical Economics in 2002. Among other professional organizations, Mr. Lewis has been active in the leadership of the National Financial Planning Association and the National Association of Planned Giving. He can be reached at chip@psafinancial.com or via editor@physicianspractice.com.

This article originally appeared in the May 2003 issue of Physicians Practice.