The Globe and Mail, Report on Business, Guest Column
Published August 1st, 2006
As I contemplate starting a new investment company, I've had to assess what form it will take. Specifically, I've been trying to decide whether the good ol' mutual fund is still a valid investment vehicle, or is it going the way of the 8-track (fortunately, I was lucky enough to avoid that stage of the audio evolution). As part of that assessment, I've been looking at alternatives and quite frankly I've been overwhelmed.
Individual investors now have a wide array of options as to how they own financial assets. These so-called “structured products” as they are called include principal-protected notes (PPNs), closed-end funds, split shares, WRAP's and separately managed accounts. In essence, investors are buying the same thing — stocks and bonds — but making choices as to how they want them packaged.
In my view, there are very few of these packages that truly make sense for the investor. One of the most popular — and also one of the most abusive — is the principal-protected note. We can't turn anywhere without being offered principal protection, and yet I think this is the most over-rated (and over-used) feature I've seen in many years. To be blunt, it's a consumer rip-off. Here's why.
First of all, most of these products have terms of five to seven years, some even longer. If you go back and look at the market data, there are only a couple of five-year periods where the markets didn't provide a positive return (and when it was negative, it was only modestly so). There has never been a 7 year period when the S&P/TSX Index provided a negative return. What downside are clients protecting themselves against?
Second, these things are very expensive. Owning these notes requires the investor to pay underwriting fees, selling commissions, management fees and insurance premiums (the principal guarantee). In bringing a PPN to market, there are a lot of hungry mouths to feed.
Related to the high cost, it is hard to see how PPNs can provide a higher return than a diversified, fixed income portfolio over the next five, seven or more years. The most likely scenario for equity markets is for single-digit returns, which assumes stocks earn a reasonable risk premium over Government bonds, which currently yield about 4.5%. With a PPN, the packaging costs effectively offset the risk premium.
Fourth, the transparency on PPNs is horrendous. It is very difficult to figure out how exactly they work and virtually impossible to figure out what fees are imbedded in the package.
Fifth, while PPNs have “potential” to generate a higher return, they also have “potential” to generate a lower return. For an income-oriented investor, they provide no certainty of income.
And finally, principal protection sounds a lot better than it is. If you only get your capital back in seven years, you must remember that inflation will have eroded your purchasing power significantly. In 2013, it will cost $1.19 to buy what costs $1.00 today, assuming a 2.5%-per-cent inflation rate.
I recently came across a National Bank Securities advertisement for the latest offering in their Blue Chip Note series. It's not my intention to victimize the National Bank, but this Euro-Pacific note is a good example of what I'm referring to. It guarantees that you get your investment back in eight years if the stock portfolio (30 well-known international companies) doesn't generate a positive return. If the portfolio is up after eight years, the investor participates fully in the return after netting out the annual 3-per-cent fee.
There is one caveat, however: The bank can redeem the note after four years if the annual return has been above 10 per cent. So if the portfolio was to do well in the first four years, the return is maxed out at 10 per cent.
Effectively, the client is buying an international index fund with a 3-per-cent fee. It could be argued that the eight-year principal guarantee is worth something, but I would suggest that it is more than negated by the performance cap in the first four years.
I think PPNs are a bad compromise. They serve neither equity nor income-oriented investors very well. Equity investors buy stocks to generate higher long-term returns on their portfolio. Higher returns come from taking more risk and being subject to some short-term volatility. If you take the risk out of the product (that is, principal-protection), it follows that you will also take out the excess return. Fixed income investors, on the other hand, buy bonds for the certainty they provide. PPNs provide no such certainty.
PPNs are like the elephant in the room. Everyone in the investment industry knows these products are not good for the client, but they're keeping quiet about it. Why? Because PPNs are big sellers and generate terrific profit margins. Financial executives may ignore the elephant, but investors would be advised to give it a wide berth.