Definition of Market Index Target-Term Security (MITTS)

The market index target-term security is a type of principal-protected note designed to provide equity exposure while protecting the initial investment. It was initially engineered by Merrill Lynch and was designed to limit the amount of downside risk an investor is exposed to, while also providing a return that is proportional to that of a specified stock market index. Market index target-term securities typically do not afford their owner the right to redeem the security before maturity, nor do they usually afford the right to call the issue in early.

Understanding Market Index Target-Term Security (MITTS)

The purpose of a market index target-term security is to provide equity exposure to an investor's portfolio while still providing a guarantee that, even if the stock market performs poorly during a specified investment horizon, they will still be left with a specified minimum amount of capital. Though market index target-term securities invest in equity markets, they are considered debt instruments.

Example of a MITTS

For example, assume an investor could purchase market index target-term security units today at a price of $10 per unit. The market index target-term securities mature in exactly one year, at which time they require the return of the $10 principal value to the investor, plus a proportional return based on the performance of the selected index, such as the S&P 500, during that time period. So, if the S&P 500 crashes during the year, the investor still receives the $10 per unit back. However, if the S&P 500 does well during the year, the investor will receive the $10 per unit back, plus an extra amount per unit that is calculated based on the S&P 500's return. A percentage of any earnings gained by the market index target-term security is generally claimed by the issuer of the security, along with standard fees.

Drawbacks of MITTS

Despite the loss constraints and reasonable lifespan to maturity, market index target-term securities have several disadvantages investors must be aware of. First, they are taxed regardless of whether the underlying index experiences gains or losses. Second, holders are strictly prohibited from selling market index target-term securities prior to the maturity date. In addition, investors who purchase these securities are trading potential upside for downside protection. While the principal is protected, the investor will only realize a portion of any potential gains.