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A do-it-yourself principal protection plan

There are lots of ways to put safety first in your investing, but one stands out as being especially bad.

It's the principal-protected note, home to about $21-billion contributed by people who took the easy way out in pursuing their perfectly legitimate goal of investing conservatively. If you're willing to supply just a little effort, there are lots better choices than PPNs.

Balanced mutual funds are a good example. We'll look at a few funds in this category that have done fine work in protecting unitholders from losses while also delivering strong gains. Plain old guaranteed investment certificates are another option. The returns aren't great, but they're utterly dependable and you'll never hold them for years and wind up with nothing more than your original investment at the end.

Another option is to construct your own PPN. It won't be anything like professionally manufactured PPNs, with their tricky fees, terms and conditions, but it will do the job of getting you some exposure to a hot-performing but risky investment category while protecting you against losses.

The problems with PPNs were highlighted late last week when the federal government issued some proposed new regulations that would require improved disclosure about their fees and inner workings. Here's a quick summary of the problems with PPNs.

Fees that undermine returns and aren't disclosed in a uniform, easy-to-grasp way.

Hazy explanations of how the underlying investments must perform in order for you to make money and what, if any, limitations there are on how much you can make.

Capital guarantees that usually don't apply if you sell before maturity.

An illiquid secondary market, which means you may not be able to sell a PPN before maturity at a decent price.

A scarcity of performance data for both PPNs themselves and the packages of investments on which they're based.

The typical PPN is a black-box financial product with nice packaging. Balanced mutual funds are just the opposite - all they do is blend stocks and bonds in a way that ideally offers some upside potential while cushioning the downside.

As it happens, bonds have had a rough year in 2007 as a result of rising interest rates, while stocks have been choppy. So it's a perfect time to monitor the safety level of these funds. Two names that stand out are Saxon Balanced and Manulife Monthly High Income, both of which are up in the low single digits this year and went through the bear market years that began this decade without losing money.

The low returns available from GICs are pretty much the story behind the rise of PPNs. Many investors are happiest with the certainty of GICs, but they can't abide making roughly 4 to 5 per cent at most per year.

It's worth remembering that GICs offer something PPNs do not, which is the certainty of a return on your investment. If you buy a $5,000 five-year GIC from ING Direct right now at 4.65 per cent, you know you'll have $6,275.76 at the end (assuming annual compounding). With a PPN, you could have more than that, but there's also a chance you'll end up with less or no gain at all.

If the idea of principal-protected investing still resonates with you, consider building your own PPN. Today's PPNs are getting increasingly complex as a result of the use of derivatives and leverage (borrowing to increase market exposure), but it's possible to keep things very simple.

Start with a strip bond with a term corresponding to how long you want your PPN to last, say five years. Strips are similar to regular bonds in that they represent borrowings from governments and corporations, but you don't get semi-annual interest payments. Instead, you buy them at a discount to the amount you'll get on maturity. The difference between what you pay and the stated maturity value is computed into an annualized return, or yield, that you can compare with other bonds, GICs and such.

The tax treatment of strip bonds means you'll want to keep your home-made PPN in a registered account. Strips may not pay annual interest, but the government will tax you as if they do in an unregistered account. And, yes, gains on strips are considered to be interest income.

If you were building your own $5,000 PPN today, you could start with a five-year Province of Quebec strip yielding 4.1 per cent. This strip was trading late this week at levels where you would pay $4,080.35 to get $5,000 on maturity.

This would leave you with $919.65 to invest with the knowledge that no matter how things turn out, your Quebec strip will be paid out at $5,000 in five years. With this kind of backstop, you can afford to get quite aggressive with your PPN.

For example, you might go with a mutual fund that invests in risky but potentially hot small- to mid-sized stocks. Dynamic Power Canadian Growth is an example of such a fund. It's up a stunning 28.1 per cent on an annual basis over the past five years, which suggests now is not an ideal time to get in if you prefer to buy low. Still, it serves as an example of how you can make a homemade PPN work if you choose the right aggressive complement to your strip bond.

At 28.1 per cent a year for five years, an investment of $919.65 would grow to $3,172.26. Add that to the $5,000 you get from your strip bond and you end up with a total of $8,172.26, which represents an annualized five-year return of 10.3 per cent on your initial $5,000 investment. That's roughly double the highest rates available on five-year GICs today.

The underlying investment of a PPN is crucial. Choose wrong and you end up with the proceeds from your maturing strip bond and little or nothing extra. To see how this might work, imagine you bought the same $5,000 Quebec strip bond and then got the 0.6-per-cent annual return the RBC Life Science & Technology Fund produced over the past five years. This would turn your $919.65 into $947.57 - add that to your $5,000 bond investment and you're left with an annualized five-year return of 3.5 per cent. In this case, a GIC or balanced fund would have likely have been a better choice.

There's no sure way to tell if your homemade PPN will beat GIC returns, but you can at least determine the return you'll need to meet that threshold. Five per cent is a top return for a five-year GIC today. If you paid $4,080.35 for a 4.1-per-cent Quebec strip bond, then you'd need a return of 9 per cent annually on your extra $919.65 to boost the overall return for your PPN up above 5 per cent.

Those handy prepackaged PPNs will take care of all these details for you, though with numerous fees and conditions. This brings us back to balanced funds and GICs. Don't buy a PPN without first checking into these stalwart friends of the conservative investor.

Heavy hitter Canadian balanced funds

We asked mutual fund analyst Ranga Chand to choose the best balanced fund alternatives for investors interested in principal-protected notes. Here are his heavy hitters in the balanced category:

FundCategoryAsset allocationMERCalendar year
StocksBondsCashBest yearWorst year
TD Monthly Income-I (Inception '06-'98)Equilty balanced63%27%10%1.41% versus 2.53%21.3%, '031.7%, '99
BMO Monthly Income (Inception '02/'97)Neutral balanced49%43%8%1.48% versus 2.51%12.5%, '030.6%, '02
Mackenzie Sentinel Income series B (Inception '01/'98)Fixed income balanced38%57%5%1.84% versus 2.23%15.6%, '002.3%, '02
London Life Income (MF) (Seg Fund) (Inception '07/'98)Fixed income balanced38%56%6%2.21% versus 2.23%13.7%, '001.7%, '99

Note:

All above funds are Heavy Hitters and have delivered above average returns over each of the past 1-, 3-, and 5-year periods relative to their respective categories

All funds have superior sharpe ratios

All funds have also posted positive returns every calendar year since their inception including during the 'Great Bear Market' of 2000 - 2002

MERs of all funds are below the median for their respective categories

How to build a principal-protected note

Despite onerous fees and conditions, PPNs have become very popular with conservative investors as a result of the fact that you'll never do worse than getting your upfront money back. There are better safe-investing alternatives, but let's say you like the PPN concept. Here's a simple, low-cost way to build your own $5,000 PPN.

Your materials

1 five-year Province of Quebec strip bond maturing Dec. 1, 2012

1 aggressive equity fund -- in this case we'll go with Dynamic Power Canadian Growth and use its results of the past five years

as a reference.

Cost

$5,000.00 total amount you'll invest in your PPN

$4,080.35 cost of $5,000 worth of the Quebec strip bond

$919.65 amount left over to invest aggressively

After 5 years

$5,000 value of your matured strip bond

$3,172.26 value of your investment in Dynamic Power Canadian Growth based on an average annual return over the past five years of

28.1 per cent (don't count on getting that in the five years to come)

$8,172.26 total end value of your PPN

10.30% annualized return of your PPN

SOURCE: ROB CARRICK, RANGA CHAND

© 2007 The Globe and Mail. All rights reserved.

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