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Mitts Are Handy In Foul Market

The Washington Post

Up a hundred points, down a hundred points. In this tumultuous market, many small investors are reluctant to commit any new money without a sense of security.

But what if there’s an investment that gives you no downside but an unlimited upside? An investment with a guarantee against loss but no restrictions on gain?

In fact, there are several such investments trading on the American Stock Exchange; they’re low-priced and easy to buy and sell - just like shares in General Electric Co. or Microsoft Corp.

These securities vary in their details, but a typical one works this way: If the Standard & Poor’s 500-stock index, a popular market indicator, goes up, you get the entire increase, often plus a bonus. If it goes down, you get your initial investment returned in full.

Talk about having your cake and eating it too.

Most of these investments are issued by Merrill Lynch & Co. and are called MITTS, or index target-term securities. Although the first MITTS were launched five years ago, few investors are aware of them.

To give you an idea of how the typical MITTS works, let’s look at the first one:

In January 1992, Merrill sold MITTS shares for $10 apiece to the public. Each share carried a promise to pay, in August 1997, an amount equal to the percentage increase in the S&P 500 over that period, plus an extra 15 percent of that, times $10 - and the original $10 back. There was another promise: If the S&P was lower in 1997 than it was in 1992, investors wouldn’t be penalized. Merrill would still return the $10 initial investment.

When the shares were issued, the S&P was 412. On Thursday, it was 925. That’s an increase of 125 percent. Add 15 percent of that and you get a total increase of 143 percent - times $10 equals about $14 per share. Add the original $10, and the shares are worth $24, which is exactly how they stood on the Amex.

Like all stocks, you don’t have to buy MITTS when they are issued. You can buy and sell them at any time, using any broker. MITTS are listed in the American Stock Exchange table (look under Merrill Lynch, or ML).

They come in lots of flavors. Merrill, for instance, offers MITTS linked to a technology index, a health care index, and others. A new inflationadjusted one guarantees investors get their $10 back plus an adjustment for increases in the consumer price index..

PaineWebber Inc. sponsors what it calls “stock index return securities,” based on the S&P 400 index of midcap stocks. And Salomon Brothers Inc. has a MITTS-style Nikkei security due in 2002 that pays the increase in that Japanese index plus a 42 percent bonus.

So what’s the catch? There are several, but none is especially significant:

First, these shares (or, technically, “units”) are obligations of Merrill Lynch - or any other issuing company. If something nasty happens to the issuer, and it can’t make good on its guarantee, then you’re out of luck.

Think of these securities as debt. After all, Merrill Lynch calls them “protected growth notes.” You loan Merrill $10 and, instead of paying you, say, 7 percent interest a year, the company pays you “contingent interest” in a lump sum at the end of several years. The amount is contingent, or dependent, on what happens to the S&P 500. (Thus, the units are derivatives since their value is derived from something else.)

Second, there’s a tax problem. The federal government now treats MITTS as though they were zero-coupon bonds (some earlier MITTS escaped that designation). In other words, you pay taxes on “phantom interest” - the amount of which is determined according to a complex formula. It could easily be 7 percent or 8 percent.

For that reason, it makes sense to hold MITTS in tax-deferred accounts, such as IRAs or 401(k) plans.

Third: you get no dividends. If you own an S&P-based mutual fund, such as Vanguard Index 500, you receive payouts that are immediately reinvested as shares in the fund. Here, you get no payout.

Finally, understand that Merrill and the other firms that offer these investments aren’t charitable institutions. While MITTS seem too good to be true, they aren’t. For instance, even though you get your money back if the S&P drops, you get no interest, and Merrill has had the use of your money for several years.

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