Investor Clinic spends a lot of time discussing worthy financial products - dividend stocks, exchange-traded funds and low-cost mutual funds, for example. Today, we'll talk about a product we think you should avoid.
They're called principal-protected notes (PPNs), and if your broker ever tries to foist them on you, we recommend you run quickly in the other direction.
Some advisers won't even touch them.
"There's nothing in it for the investor. There are so many hidden fees and markups. The dice are loaded against the individual," said Hank Cunningham, fixed-income strategist and adviser at Odlum Brown in Toronto.
what's a PPN?
PPNs appeal to both the fear and greed of investors, which explains why they're popular. Their chief selling point is that they guarantee to return your principal after a certain number of years - that's the "principal-protected" part - while holding out the possibility that you'll make a higher return through their exposure to a basket of stocks, commodities or other assets.
Often, PPNs use complex options and other derivatives the average retail investor has no hope of understanding. For all the unfathomable jargon in the prospectus - if the investor reads it at all - buyers are seduced by the fanciful notion that they can take no risk and still achieve solid returns.
But as we'll see, the principal guarantee comes at a stiff price in the form of punishing fees. What's more, many investors fail to realize that, even if they get their money back after the note matures - five, 10 or more years down the road - they'll still be under water because inflation will have eroded the value of their principal.
fat fees
Most PPNs charge fees ranging from 3 to 5 per cent, said Nigel Roberts, president of Bluenose Investment Management in Kelowna, B.C. In other words, that's the amount you'll have to recoup on your investment before you can even think about making a profit.
It's like running a race with a 10-kilogram weight tied around your leg.
"They've got a lot of high costs embedded in them, and basically in most cases you're limiting your upside potential considerably," Mr. Roberts says. When clients ask about PPNs, "I just say generally I don't think they're a good idea."
With derivatives-based PPNs, figuring out what fees are being charged is especially challenging. That's because the fees are factored into the price of the underlying options, so only a derivatives expert can figure it out, said Peter Loach, an independent analyst.
Further, he pointed out that many PPNs linked to a basket of stocks don't pay out dividends to the investor. That's troubling, given that dividends are a crucial component of an investor's total return, he said.
"With PPNs, in most cases clients do not understand what they're getting. They don't understand what the fees are. They don't understand what they'll probably get versus what they think they'll be getting," he said.
What many PPN investors got during last year's financial crisis was a nasty surprise: Dozens of PPNs went into "protection" mode. That means investors will get their principal back - and nothing more - when the notes mature years from now, even though markets have staged a powerful rebound. And to repeat, that principal will have less buying power because of inflation.
make your own PPN
If you like the idea of keeping a chunk of your money safe while getting some exposure to the potentially higher returns of stocks, there's a simple way to build your own PPN. The difference is that your homemade PPN will have dramatically lower fees and none of the opaque derivatives.
Let's let look at an example provided by Mr. Cunningham, a fixed-income expert and author of In Your Best Interest: The Ultimate Guide to the Canadian Bond Market.
Suppose you have $100,000 to invest and you want to be sure you'll get at least that much back - hopefully much more - when your PPN matures.
Step one: Buy $100,000 face value of a Province of Ontario strip bond maturing on Dec. 2, 2015. Strip bonds pay no interest - their coupons have been "stripped" - but sell at a discount to their face value, which the investor receives at maturity. This particular bond can be bought today for about $81,530.
If you're confused by this, the important thing to remember is that you can pay $81,530 now and get back $100,000 when the bond matures six years from now. (That works out to an annualized return of about 3.4 per cent).
Step two: Take the $18,470 still in your pocket (The $100,000 you started with minus the $81,530 price of the bond) and invest it in a low-cost index ETF such as the iShares CDN LargeCap 60 Index Fund. This popular ETF has a tiny management expense ratio of 0.17 per cent and invests in blue-chip Canadian companies. It has a dividend yield of about 2.5 per cent.
Absolute worst-case, doomsday scenario? If every single company in the ETF goes bankrupt and your equity investment falls to zero, you'll still get back $100,000 on your bond investment - unless, of course, the government of Ontario defaults. This seems highly unlikely.
More likely scenario: You'll collect regular dividends from the ETF, possibly realize a nice capital gain over the next six years and get your $100,000 back. Oh, and one more thing: You'll have the satisfaction of knowing that some derivatives whiz didn't help himself to a chunk of your savings.
© The Globe and Mail
