It has taken far too long but finally our securities regulators are cracking down on the way in which principal-protected notes (PPNs) are sold.
The Canadian Securities Administrators (CSA), which represents our patchwork quilt of regulatory bodies, has issued a notice that it expects all registered dealers to apply the know-your-client and suitability rules before recommending the purchase of PPNs to anyone. Even more to the point, the CSA says it wants the banks and other deposit-taking institutions to use the same standards. Banks have been the biggest issuers of PPNs, led by BMO and CIBC, but until now the sales of these securities have largely been unregulated. That's going to change.
All I can say is that it's about time. The financial industry has been raking in billions of dollars from PPNs, peddling them to people who, in many cases, have little understanding of how they work.
The main sales pitch is safety. PPNs guarantee you'll get your capital back at maturity, no matter what happens. Whether you receive anything more depends on the performance of the security the PPN tracks. That could be a single stock index, one or more mutual funds, a portfolio of blue-chip stocks, a basket of selected stocks from a single sector (e.g. mining, agriculture, energy), or almost anything else.
With memories of the 2008-09 market crash still raw, many people are attracted by the idea of investing in a security that offers exposure to the stock market without putting their capital at risk. That provides a comfort blanket to nervous investors.
What these people often fail to understand is the high price they pay for PPNs in fees and commissions or the fact that many PPNs have a cap on how much they will pay out if things go well. Moreover, they don't think about the fact that a zero return after tying up money for as long as five years is the same thing as a loss. The purchasing power of the capital has been eroded by inflation over that time and any interest or dividends that would have been earned by investing in conventional securities have been lost forever.
In a document published on its Investor Tools page, the CSA lumps PPNs into the Alternative Investments category, along with options, futures and forward contracts, foreign currency trading (forex), and hedge funds.
"Each of these different types of investments has medium to very high risk. They also have various costs associated with them, which could include: commissions, sales fees, management fees, operating fees or early redemption fees, among others," the CSA warns. "They are meant for very sophisticated investors or investors who can afford to take higher risks and pay for specialized advice… Although you may be offered an investment in this class, it is important that you be comfortable with all risks and costs involved, and never invest in anything you don’t fully understand."
The track record of most PPNs is not encouraging. Globefund includes them in its Miscellaneous – Other Funds category which has 1,128 entries. I did a search to see how many funds in this group beat the 6.21 per cent average annual compound rate of return of a Canadian neutral balanced fund over the three years to July 31. Only 49 funds passed the test and most of those were not PPNs.
The most successful PPNs I found were the six series of Principal Protected Blue-Chip Notes issued by Sentry in 2004 and 2005, most of which showed three-year returns that were roughly double the balanced fund average. However, because of the effect of the 2008-09 crash, their returns since inception were much less impressive, ranging from 4.1 per cent to 5 per cent. That's high by PPN standards -- most issues don't come close. But it's not likely to excite many people, especially after they look closely at the costs and risks involved.
The bottom line is that investors should not allow themselves to become so fixated on the guaranteed principal pitch that they lose sight of the costs and risks involved. PPNs are a pure sales gimmick, albeit a successful one. Avoid them.
This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada's top money experts. For more information about becoming an Internet Wealth Builder member, go here.
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