The Globe and Mail, Report on Business
Published November 1, 2008

I've called them the worst of both worlds - bad for equity investors and inappropriate for those seeking a predictable flow of income. And professional money managers would never buy one; the odds are stacked against them.

I'm talking about principal-protected notes, or PPNs. These are investment products with catchy names like American Blue Chip Dividend Enhanced Protected Notes Series 8. PPNs are big sellers because they give investors a chance to participate in the returns of an index, mutual fund or hedge fund without putting capital at risk. In other words, the worst-case scenario is that holders get their money back after five or more years.

The Street is deeply divided on PPNs. There are firms making a good living off them, including banks and the asset managers who lend their expertise and brand to the products. But there are a number of firms that don't want to be associated with a PPN: AIC, Brandes and yours truly, to name three. Generally, the abstainers are firms run by investors and with a strong investment philosophy.

What everyone agrees on is that PPNs have problems. Disclosure is poor and advisers and clients often don't understand the possible outcomes. And until recently, when the federal government mandated certain disclosure requirements, there has been no impetus for change because PPNs fall between the regulatory cracks. They are sold by advisers but categorized as a banking product, so concerned investment industry regulators have no jurisdiction.

One poorly understood feature of PPNs is that their potential return is "path dependent." (Note: I am specifically referring to the ones categorized as Constant Proportion Participation Insurance. Look that up in Wikipedia for fun.) In other words, it's not only the market return that determines how the product performs, but also the path it takes to get there.

Because of the "protection" feature and the use of leverage (in some cases), if the underlying fund or index goes down substantially at the beginning of the note's term, then a "protection event" occurs and the note is monetized. When this happens, the market exposure is reduced or eliminated, and the remaining assets are invested in bonds in order to ensure that investors get their capital back. When the market goes back up after such an event, investors have no skin in the game and therefore no possibility of positive returns.

It was reported this week that a significant number of PPNs have had a protection event. Bank of Montreal is the leader with 69 such notes. Because of the weak markets, these notes no longer have any upside potential, even though some have five or more years to run. Who knew?

Because I've been critical of PPNs, as well as other expensive structured products, I've been asked by some readers (and my editor) what I think about them now. It's a fair question because in the face of huge declines in conventional equity and balanced portfolios, PPN holders at least have the comfort of knowing that they are going to get their money back a few years down the road. That feels like a good result and in some cases it may be.

Regardless, my view hasn't changed. There are times when holders will beat the odds, but the overall weaknesses of PPNs remain.

If we've learned anything in the past year, it's that we don't want to buy something we don't understand and/or is a layer or three removed from the underlying asset, whether it be stocks, commodities or home loans. Because of their complexity and poor disclosure, PPNs are incomprehensible to all but the most sophisticated investor and adviser. Most people can't possibly know what tradeoffs they are making when they buy a note.

I thought Jonathan Wellum of AIC expressed it well when he said: "PPNs behave opposite to what a successful investor would do." They sell when markets are down and buy (and sometimes lever up) when markets are up.

I encourage investors who are considering a PPN - those who have little tolerance for downside risk and are willing to tie their money up for five to seven years - to look elsewhere on the product shelf for something with a reasonable fee and a boring name, such as "conservative balanced fund." I firmly believe that these will handily beat PPNs. At this point in the market cycle, investors have the odds stacked heavily in their favour. It is not the time to turn that advantage over to the house.

As for my troubled industry, it is the time for the investment types at the big institutions to speak with a louder voice and get PPNs pulled off the shelf. It's a hard decision to make because they could be big sellers over the next year, but it's time that investment rationale overruled the marketing imperative.