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How do I hate PPNs? Let me count the ways

Just when you thought all the reasons to hate principal-protected notes were out in the open, along comes something new.

PPNs are too expensive to buy and own as a result of their guarantee that you won't lose money. They're also too sneaky in disclosing pertinent details, and, we have just learned, they're sometimes too cute in their investing strategies.

Some background: The month of January was a nasty one for the stock markets and, in turn, for the mutual fund industry, which suffered its worst month in ages. Those silly retail investors, you might conclude here. They bailed out and look what happened. The markets snapped back, recent volatility notwithstanding.

If you look deeper into the redemption numbers, though, you'll find that it wasn't just individuals who defied basic investing wisdom and sold after a setback. Financial pros who run PPNs were also sellers.

You can see this happening in a report that CI Financial Income Fund issued last month about its January sales. In explaining the environment experienced by its mutual funds during the month, CI mentioned $310-million in redemptions related to several series of deposit notes, another term for PPNs. CI's funds were used in the PPNs, but the actual issuer of the notes can be a bank or other financial firm.

CI said these notes "use asset allocation strategies in which money is moved out of the underlying funds when related markets are declining." In PPN-land, they sometimes call this a dynamic asset allocation strategy. Basically, it means fleeing when markets fall.

Though they've been warned ad nauseum about this self-destructive behaviour, retail investors continue to sell at the wrong times. The interplay of money and fear are at work here, so it's understandable. But what gives with the people running those PPNs?

The answer is that they're trying to preserve the guarantee that is the prime selling point for PPNs with their unsophisticated, security-obsessed clientele. You want a guarantee that you won't lose money in the stock market? OK, but you'll pay for it, big time.

One way is through the fees that are sprinkled throughout the PPN structure almost like salt on French fries. Another is in the way that some of these products are managed in times of market volatility.

Imagine a PPN that offers an opportunity to invest in a major equity mutual fund without risk of losing money. There are a couple of ways a PPN can pull this off. One of them is the dynamic asset allocation strategy, which uses a preset point at which losses must be stopped to preserve the guarantee. One PPN issuer calls this a "protection event."

When one of these events occurs, the assets in the PPN portfolio are transferred into bonds, which can be relied upon to preserve and grow the remaining funds so that the capital guarantee is preserved.

So, great, your initial investment is safe. But what about growth? Here, things look grim.

According to an information sheet from the PPN issuer mentioned above, portfolio assets will be shifted into bonds in a major stock market decline. "As such, the investor will not participate in any subsequent performance (positive or negative) of the fund."

If a protection event happens late in the term of a PPN, then you may still have enough gains from previous years to finish up with more money than you started with. If the event happens early on or in midterm, then you may just end up with nothing more than your money back.

"This is just one of the problems with these types of investments," said Andrew Teasdale, an investment industry consultant who has studied PPNs. "You're going to be forced to sell at lower market valuations. And once the market has fallen and they've switched back into bonds, they're going to miss out on the rebounds, too."

Not all PPNs are constructed this way, but no matter. When you look at returns for the broad PPN sector, you can see how problematic it is to make returns that beat risk-free guaranteed investment certificates.

In the database, there are 31 PPN issues with a three-year history (this is just a sampling of the overall selection). Just 12 of them offer higher returns than you could have got with a five-year GIC purchased three years ago, and six of the 12 are based on hedge funds as opposed to the mutual funds, stocks and commodities to which most are pegged.

What's sort of pathetic here is that some investors will be grateful for getting their capital back at maturity. The company that issued their PPNs will have made good money, but these individuals will have passed up a chance to lock in a safe GIC return so they can gamble on something better.

Oh, by the way. Don't expect the exalted capital guarantee on PPNs to apply if you have to sell before maturity. It's another reason to hate them.

Investing the PPN way

More than $21-billion has been invested in principal-protected notes, which guarantee that you won't lose money if you invest in portfolios of mutual funds, stocks, commodities and other securities and hold until maturity. PPNs have embedded costs that affect returns, and they're run in a risk-averse way that can also undermine gains. Here's how a selection of notes tracked by have performed in the past three years.

NoteThree-year return (annualized)
BluMont MAN IP 220 Ser 2 Notes15.5
CIBC FULPaY AGF Fund Notes Series 29.5
CIBC FULPaY CI Fund Notes Series 14.6
OPS Global Titans 50 Notes S2 (SG)3.3
BMO FTI bestLINK Alternative S11.1
CIBC Yld Generation Deposit Note S2-0.6
ONE All-Star Portfolio Note 2-1.1
ONE MSCI Hedge Invest Index Note 2-5.6



© 2007 The Globe and Mail. All rights reserved.

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