Merrill Lynch MITTS - What are they and should you use them in your portfolio?

Debt securities whose returns are tied to equity indexes were first
introduced during the bull market of the mid-1980s.  The recent
economic and market trends have caused a resurgence of interest in
these securities.  The Index Investor's (subscription only) editor, Tom Coyne, recently took a close look at one such security called
MITTS.

MITTS are debt securities issued by Merrill Lynch, whose return is tied to some type of equity index. They are a subset of a broader class of instruments known as "equity linked notes" that are issued by many different companies.  While each of these typically has a somewhat different structure, the general structure is that of an intermediate term debt security whose return is equal to the positive percentage change in the value of an equity index, less some amount.

Some investors find these ELNs to be attractive, because they provide principal protection (assuming no default by the issuer), and some upside participation in the appreciation of an equity index. We are considerably less enthusiastic about them, for two reasons.

First, the basic structure of an ELN can, to some extent, be replicated by an investor if he or she is so inclined. In principal, an ELN is nothing more than a bundled combination of a zero coupon bond and a call option on an equity index (with both having the same maturities). The wrinkle with equity linked notes is that they typically have a longer maturity than the longest dated traded call option on the equity index they use. This creates potential for the mispricing of the equity option that is embedded in the ELN. Specifically, it is hard for most investors to tell whether the percentage that is deducted from the percentage return on the equity index (under most ELN structures) represents fair compensation for the option.

Second, ELNs encourage investors to think about risk and return issues at the level of an individual security, rather than at the level of their portfolio. For example, the same risk reduction benefit that is provided by an ELN can be achieved (more cheaply) by varying an investor's portfolio allocation to various asset classes (e.g., bonds and equity).