Bad Investments: Accumulators

Last Updated Jul 2, 2009 9:59 AM EDT

Yesterday, we took a look at one category of structured investment products called reverse convertibles. Today, we'll look at a similar product popular in Asia called accumulators.

An accumulator is essentially a contract that obliges investors to purchase a security, currency or commodity at regular intervals at a fixed price. The obligation lasts for the term of the contract, typically one year. Perhaps the most attractive feature is that the fixed price is set at a significant discount to the prevailing market price. Obviously, accumulator investors make money even if the security price is stagnant. In a bull market, who can resist the opportunity to buy a stock at a discount from its current market value?

However, if the security price drops, investors remain locked in to purchasing the security, even if they are paying more than the security's prevailing price. The following example from The Wall Street Journal illustrates not only how accumulators work, but also why they eventually became known as "I'll kill you laters."

In late 2007, China Mobile, one of Hong Kong's largest telecom stocks, was trading around 142 in Hong Kong dollars. An accumulator might have offered investors the ability to buy 1,000 China Mobile shares every month at 114, or 20 percent below market price. It is important to note that accumulators typically have a clause that terminates the contract if the stock reaches a certain level, which is typically slightly higher than the initial price. However, the investor was committed to buying 1,000 shares each and every month for the length of the contract, no matter how low the price went. As you can see, the losses could be huge.

Making matters worse was that many of these accumulators contained a "poison pill." For example, investors could be required to double down on purchases if shares dropped, buying 2,000 shares instead of 1,000 -- at a price that immediately put them in the hole. Investors purchasing a China Mobile 12-month accumulator, set in November 2007, would have quickly found themselves in this situation as the stock fell to $71.60 -- down 37 percent from the 114 purchase price. And because the investor was locked into making more and more purchases over the life of the contract, the losses piled up with each purchase.

Investors seeking to accumulate wealth are best served by avoiding structured products. As I mentioned yesterday, companies do not issue securities like this to help investors. They do it to raise capital at a cheaper cost. If you find yourself attracted by the desire to be a member of the private club that gets exclusive access to these special deals, you would be best served by remembering Grouch Marx's words of wisdom: "I don't want to belong to any club that would accept me as a member."

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.