Zvi Bodie, finance professor at Boston University and author of Investments, a leading finance textbook, has a suggestion for conflicted investors who want to protect principal while making aggressive stock market bets.
Here's how it works: Say you have $100,000 to invest, and you'll need it in three years. You buy $88,900 in 3-year certificates of deposit with an annual percentage yield (APR) of 3.95%. In three years you'll have just a bit over $100,000. That leaves $11,100 for a riskier play.
Some people might want to take a flyer on a bank stock or gamble on an emerging market. But Bodie likes the Long-Term Equity Anticipation Securities (LEAPS) tied to the Standard & Poor's 500-stock index and sold by the Chicago Board Options Exchange. It's a three-year call option—a bet that the market will rise—and can be exercised only just before it expires. The less likely the call is to pay off, the cheaper it is to buy.
Bodie says $11,100 can buy roughly 20 S&P 500 LEAPS that will pay off if the index doubles in price in three years. If that doesn't happen, the option expires and you've lost your $11,100. You still have $100,000. But if the market does come through for you and doubles, you'll pocket $20,000 for every percentage point above that mark. So, if the S&P 500 winds up 10 percentage points above your target, you'll have $300,000—$200,000 from the option plus $100,000 from the CD, before costs and taxes.
Clues from a Pack of Bears
It would have taken a crystal ball to know that the Standard & Poor's (MHP) 500-stock index would bounce after hitting a new low for the year on July 15. But watchers of the Nova/Ursa Ratio, a gauge of investor sentiment used by Schaeffer's Investment Research, had a good idea something was up. The ratio is based on asset flows into the Rydex Nova Fund, which uses leverage to return 150% of the S&P 500's performance, and the Rydex Ursa Fund (RYURX), which shorts the index. Schaeffer divides the assets that flow into Nova by those going into Ursa, after factoring out market movement (Rydex publishes fund prices and total assets daily, so it's possible to determine asset changes based just on money flows). Bullish investors buy Nova and sell Ursa; bearish ones do the reverse.
The lower the number, the more bearish the sentiment—and investors tend to be most bearish just when a market is set to rise. On July 7 the indicator sank to 0.61, below its level when Bear Stearns nearly collapsed. That signaled a possible bounce; six trading days later, the market rose. The ratio is "a complementary tool," not a replacement for fundamental and technical analysis, says Todd Salamone, Schaeffer's senior vice-president for research.
Charity, Dressed Up as a Fund Fee
Here's a novel come-on: Invest in my mutual fund, and a third of my 1.5% management fee will go to charity through an affiliated foundation. "It's a way for charities to gain money without asking for donations," says Bill Davlin, whose $1.6 million (mostly his own money) Davlin Philanthropic Fund launched in July. It's a creative idea, and some 300 nonprofits signed on. (Investors can decide where their money goes.) But it doesn't make sense at tax time, and Davlin's history managing other people's money is minimal. (He picked stocks at Royce Funds in his twenties before becoming the chief financial officer of a Web ad firm for 10 years.) Giving via his fund could mean losing tax benefits. Charitable gifts are deducted from taxable income, while management fees (like Davlin's donations) reduce net asset value. Taxes aren't the point, Davlin argues. "The question is, are you going to pay those fees to your portfolio manager or your favorite charity?" For big givers, donating appreciated securities on their own is the smart move. Givers can take the charitable deduction for the (higher) market value and avoid capital-gains taxes on the gift.