TORONTO (GlobeinvestorGOLD) - I don’t like principal protected notes (PPNs). I have said this before but my concerns about this hybrid product have had approximately the same effect as King Canute trying to hold back the tide. Investors seem to love these things and Bay Street responds by cranking out more of them almost on a daily basis. Last Thursday, for example, RBC announced a new issue based on commodities while BMO and Mackenzie Financial teamed up for two new products based on Mackenzie mutual funds.
There are a lot more in the pipe, and why not? If people want to line the pockets of underwriters and financial advisors by paying hefty commissions for the peace of mind of capital protection, the financial community is only too happy to oblige.
There are literally hundreds of these notes out there. If you click on the Miscellaneous category on Globefund, you’ll find 651 entries, most of which are PPNs. I don’t claim to have analyzed them all, but the spot checks I did this week confirmed my skepticism about these structured products.
Before I give examples, here’s a quick primer on how they work for those who may not be familiar with them. A classic PPN tracks a benchmark index or indexes. But more often these days they track one or more mutual funds, a basket of stocks, one or more commodities, a hedge fund, a collection of indexes, a hot stock category, or just about anything else you might imagine. Each note has a maturity date, which is usually from three to 10 years from the date of issue, and is on sale only for a limited time. The investor’s principal is guaranteed – if there is no profit at the maturity date, the capital is refunded. (There are some non-principal protected notes as well, but they’re another story). Investors pay a sales commission at the time of purchase and there is usually a hefty annual fee as well.
The banks are among the largest promoters of PPNs, so let’s look at a couple of past issues from them, selected at random.
First up is the BMO CI Linked Notes S1 from Bank of Montreal. These were issued in March, 2005, and they track the performance of a portfolio of units of CI Canadian Investment Fund and CI Signature High Income Fund. The units carry an annual management fee of 2.95 per cent. According to the performance numbers on Globefund, these notes had a two-year average annual compound rate of return of 3.34 per cent to Aug. 31. By comparison, the CI Canadian Investment Fund gained an annual average of 10.18 per cent during that period while Signature High Income averaged 5.47 per cent. Assuming a 50-50 portfolio split, that works out to an average annual return of 7.83 per cent for investors who simply invested directly in the two funds – more than double the return on the PPN. To add insult to injury, both funds reported MERs that were much lower than those of the PPN.
Let’s look at another mutual fund-linked note, this one from CIBC. It’s called the CIBC FULPaY Franklin Templeton S1 note and it has a neat little kicker. This PPN, issued in January, 2004, offers a return based on the best performer among seven Franklin Templeton funds in any given year. They are Templeton Global Smaller Companies Fund, Mutual Beacon Fund, Bissett Canadian Equity Fund, Templeton International Stock Fund, Bissett Income Fund, Bissett Bond Fund, and Bissett Dividend Income Fund. This PPN showed an average annual compound rate of return of 4.66 per cent for the three years to Aug. 31. And how did the individual funds do from 2004 to 2006? (Obviously the 2007 winner has not been factored in yet.) In 2004, the best performer was Bissett Income, with a gain of 22.73 per cent. In 2005, the list was topped by Bissett Canadian Equity, which was ahead 19.1 per cent. The 2006 top gainer was Templeton International Stock, at 28.15 per cent. You’d think that all those numbers would work out to a lot more than a 4.66 per cent annual return, wouldn’t you? Nope! In fact, every individual fund on the list had a much better three-year return than the PPN holders received, except Bissett Bond.
Why such poor results? Two reasons. First, the annual fees are high. But more important, a large chunk of your invested money goes to purchase a stripped bond or derivative that provides the return of capital guarantee at maturity. So only a fraction of the invested amount actually works for you.
I have used mutual fund-linked PPNs for these examples because their performance numbers are easy to track and compare. However, most PPNs are structured in such a way so as to make accurate comparisons difficult. They may be based on mixed baskets of Canadian and foreign stocks, a mixture of indexes, a collection of specialized stocks (CIBC has one based on climate change and another based on biofuel issues), etc.
Last week I received a question from a reader asking about a new PPN currently being marketed by TD. He wrote: "Would you recommend purchase of the just announced TD Dividend Income Fund - Linked principal protected notes Series 1 (Return of Capital)?"
These PPNs track the performance of the TD Dividend Income Fund. They have a term of 6.5 years, maturing on May 9, 2014. The return is based on the results of the benchmark fund over the life of the notes and the principal is guaranteed in the event of any loss. They carry a sales commission of 5 per cent and an annual “ portfolio fee” of 2.2 per cent.
This offering is yet another example of why I don’t recommend PPNs. In this case, investors are being charged hefty fees to invest in a product that tracks a mutual fund that rarely loses money. During the bear market of 2000-2002, this fund made gains in every single calendar year. In fact, the worst 12-month loss it ever sustained was a drop of 5.4 per cent during the year ending March 1999. Why would you simply not invest in the fund, which is no-load and has a management expense ratio of only 1.94 per cent? This PPN will make the underwriter and the sales agent richer but it won’t do anything for the investor.
It is issues like this that make TD Bank so profitable! You don’t need to contribute a few dollars more to their bottom line by buying them.
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