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04-Jun-2010 | Reggie | From an outside glance, it is easy to see the appeal behind investments like PPN’s. The basic premise of the product is to give investors the potential to earn a decent return based on an underlying product (such as a hedge or mutual fund), but if it doesn’t perform, the investor will get the original amount of their investment back. To many this sounds like a fantastic deal, but if you are locked into these products for a 5 or 10 year term and all you have to show is your original investment, its not such a sweet deal. If your risk averse you would be far better off investing in old fashioned fixed income investments like a bond or GIC. These type of investments are wide spread thanks in part to the ease in which they can be sold. Like all things, if it sounds too good to be true, it is.
The math behind the products is absolutely mind boggling. There have been efforts made by the regulators to increase the regulation and disclosure of the Principal Protected Notes, but very little progress has been made. The formulas and returns are based on complex derivatives and relative return weightings that result in you never getting back what you think you should. Last month the Globe and Mail’s Fabrice Taylor took a look at one called the CIBC US Dollar Premium Yield Note. It was offered in July of 2008 with a 4 year term and is comprised of 10 blue chip companies listed on the NYSE. If all the stocks go up, investors are promised a return coupon of 10% annually. Unfortunately, since July of 08 the average return for these stocks is -3.4%. This means holders of the note have probably received $0. If an investor would have bought a GIC paying 4.5% instead, they’d have a total return of 9% by next month. Fabrice goes on to discuss the lost potential by not holding the stocks themselves. He supposes for the next 2 years the stocks return an average total return of 9% per year. This brings the return to 17% over 4 years. So holding the stocks themselves would be better than holding the PPN, even though the market went through one of the worst crashes in many years.
This should be a huge concern for anyone who invests in these products. The lack of disclosure, sketchy math, and poor returns don’t offer a very strong argument for buying the notes. If you are the type of investor worried about declining markets, buy a fixed income product like a bond, GIC, or Preferred share. The lower return should hugely outweigh the potential return of the 0% you could receive if you buy a Principal Protected Note. If you are an investor who is not afraid of declining markets and see them going up in the future, you’re probably far better off buying the stocks or underlying product itself. Either way, it seems that buying the Principal Protected Note is the wrong thing to do.
