Portfolio manager Cale Smith on investing, Spoke Funds®, and Islamorada in the Florida Keys.

I don’t mean building a car – see this guy to do that. I’m referring to a bond that can be converted into stock.

Convertibles are hybrid securities with the features of both stocks and bonds. They usually have lower yields than regular bonds, but an owner receives the right to convert the bond to common stock at an agreed upon price. So, convert owners can receive guaranteed interest payments and still benefit from growth in a company’s stock.

While the market for converts in the U.S. is very liquid, not all companies issue them. Fortunately, you can create your own. You can also think of building your own convertible as a way to create a dividend from a stock that doesn’t pay one. So if building an annuity is not your thing, but you’d like to dip a defensive toe into the stock market, here’s another low fee option.

You can create a “synthetic convertible” by combining interest bearing securities and call options. LEAPS in particular can enable you to benefit handsomely from mispriced assets – if you have a long-enough time horizon.

“90/10″ is one way to build a synthetic convert. That means 10% of the cash you want to invest goes into call options and 90% goes into an interest bearing security, such as a CD, that is held until the options expire.

The options provide built-in leverage and give you the right to buy shares in the company – just like a real convert. The CD limits your downside risk, meaning your loss exposure is limited to the amount of the call premium less the interest you earn on the CD.

That’s all there is to it. A guaranteed return plus the chance for an equity kicker. Now you can impress folks down at the dock. Plus, with an attitude and $20,000 you can go start your own hedge fund.

Morningstar has a good free guide to options for beginners here. There’s more on converts here, too.

Annuities seem to be enjoying a resurgence lately, thanks to the bear market. That’s a shame. Many companies sell annuity products that are so costly in terms of fees and penalties that they seem better suited for funding the salesperson’s retirement than the investor’s. Amazingly, some agents even recommend buying annuities inside an IRA, meaning investors are paying extra to defer taxes…on an account that is already tax-deferred.

I can certainly understand the appeal of secure returns these days, but buying an annuity too often means being locked in to high fees and low returns. You can get the same security and pay zero fees by building your own annuity. Here’s how:

Let’s say you have $50,000 to invest for five years. You don’t want to lose any money under any circumstances, but you’d also like to make some money if stocks go up.

First, find a high yielding five year CD that is insured by the FDIC. Currently, you can find some on Bankrate.com that yield 3.50%. (Rates will likely be higher in the coming months.) If you buy the CD in your IRA, then you’ll create the same tax break found in an equity-indexed annuity.

At a yield of 3.50% you’ll need to invest $42,099 today to have $50,000 in 5 years. (Here’s a calculator.) Take what’s left and invest it in a low-cost index fund like the Vanguard 500.

In five years, you’ll get $50,000 back, guaranteed. If the market goes nowhere, you’ll still end up with $57,901. If stocks earn 7% per year, you’ll have $61,082.

You get the idea. Creating recurring payouts means splitting up the initial sum and investing in CDs with staggered terms. Email me for help plugging in real numbers. And please think hard before buying an annuity.

Additional articles:

The Downside of Market-Proof Annuities.
Consider Annuities – But as a Last Resort.
Retirement Plan Ripoffs.
Added Value – and Anxiety – For Variable-Annuity Owners.
Not So Easy Riders.

Kiplinger’s reports that expense ratios for stock mutual funds are rising, despite a horrific year of performance for most funds.

As described in the article, when assets in a fund fall below certain “breakpoints,” management fees as a percentage of assets increase.

So it could very well be the case that you, my dear mutual fund investor, not only saw your holdings decline in value by 50% last year, but you may have also paid taxes forced onto you by your fund…and now the fees you pay as a percentage of your assets could be going up, too.

You’d think that mutual fund companies might see an opportunity in that scenario to make it up to their investors by, for instance, lowering the breakpoint, or waiving the fee increase for their most loyal investors. At the very least you might think the fund companies would let their investors know that expense ratios will be increasing. Alas, neither will happen.

Mutual funds are broken.