I stumbled across a large ad in the Vancouver Sun last week that caught my attention.  The headline: Retire 12.2% Faster.  How could I not read on!

The ad was from the Bank of Montreal and it was referring to the return of one of our favorite products here at Steadyhand – the principal-protected note (PPN).  The note in question was the 5-year BMO S&P/TSX 60 Market Index GIC.  It matured on November 1, 2007 and provided a return to investors of 12.2% compounded annually.  Not bad at first glance.

When I went on to read the fine print, I learned that the actual return of the note over the 5-year holding period was 78.1%, based on a participation rate of 65%.  In other words, investors participated in 65% of the gains that the index produced over the relevant period.  According to BMO, the index upon which the note was based returned 133.8% over the same period – that’s 18.5% compounded annually.

Time for some quick math.  If you invested $10,000 in the BMO note back in 2002, you would have received $17,781 at maturity on November 1, 2007 (12.2% compounded annually).  If you invested in the same index (through an ETF) without the principal-protection wrapper, you would have received $23,376 at maturity (18.5% compounded annually).  That’s 34% more than what the PPN provided.

An obvious question arises at this point.  Is principal protection worth 1/3 of your return?

Let’s dig a little deeper.  Because of the structure of PPN’s, the gain on the product is taxed as interest income.  The gain on an ETF is taxed as a capital gain.  We all know capital gains receive much more favourable tax treatment than income, so add another strike against the PPN.

Now let’s revisit that index.  As noted, the return of the PPN is based on the return of the S&P/TSX 60 index, which returned 18.5% compounded annually according to BMO.  Upon closer look, this excludes dividends.  The return of the S&P/TSX 60 Capped Total Return Index from October 31, 2002 to October 31, 2007 was 21.7% (this includes dividends).  12.2% isn’t looking so good anymore.  To be fair, you would’ve had to pay an annual fee of 0.17% for holding the ETF, as well as a commission for purchasing the fund.  So let’s call the net return 21.5%.  That’s over 40% more than what the PPN provided.

When you factor in taxes and dividends, you are giving up a lot more than what you may think for principal protection.  But that’s not in the fine print.