Buy what you understand

Zoomer | November 21st, 2008

A generation ago there was a saying in the investment industry that “mutual funds are sold, not bought”. The implication was obvious: since people didn’t know much about mutual funds, the only way they could be persuaded to part with their money was through some aggressive selling. Since those were the days when investors had to pay an up-front commission of 9 per cent to buy in, fund salesmen (there were few women in the business back then) were often likened to their used-car counterparts.

Of course, all that has changed over the years and mutual funds are now held by a majority of Canadian households, either directly or in RRSPs, pension plans, etc. Most people know what they are and how they work.

I make this point because one of my fundamental principles of good investing is never to put money in something you do not understand. That applies to some of the exotic products that have been spun off from the mutual funds industry.

It has now reached the point where people who think they are investing in a mutual fund may in fact be buying something quite different. For example, I recently received this e-mail from a reader.

“I am being advised to switch money into the BMO Lifestage Retirement Income Portfolio. Do you have any comments regarding this fund? I couldn’t find it in your On-Line Buyer’s Guide to Mutual Funds“. – Ivan M.

There’s a very good reason why our reader could not find any reference to this security – it is not a mutual fund. We don’t know exactly how the security was presented to him but in fact it is a principal-protected note (PPN) with a return that is tied to an underlying portfolio of BMO mutual funds. No wonder he was confused!

At first glance, this looks like a very attractive place for your money, especially in these troubled times. The promoter, Bank of Montreal, says the investment offers “principal protection through guaranteed capital distributions and exposure to the growth potential of mutual funds”. Their website promises “Annual capital distributions of 6 per cent (payable monthly) for up to 15 years” plus annual inflation adjustments.

There are asterisks beside each of these promises and some fine print below. Anyone who takes the trouble to read the faint grey type will learn that the monthly payments ” are repayments of principal that will reduce the adjusted cost base of your investment in the LifeStage Notes…Capital distributions will only continue until $99 of the principal amount of the $100 LifeStage Note has been repaid to the holder, after which no further capital distributions will be made on the LifeStage Notes”.

As for the inflation protection, it’s only valid “As long as a Capital Preservation Event or Extraordinary Event has not occurred”. That happens when losses within the portfolio reach a point where all the remaining assets must be devoted to protecting the principal. Any growth potential is lost. Recently, many PPNs such as this one have been forced to declare such “Capital Presentation Events” or “Protection Events” as they are also called.

There’s more. If you read the detailed Information Statement (IS) that provides all the details of the product, you may come away with a much different impression than that conveyed by the sales pitch. Here are a few points from the IS that caught my attention. All are direct quotes from the document.

1. A LifeStage Retirement Income Note is an unsecured and unsubordinated debt obligation owed to its holder by Bank of Montreal.

2. These payments are a return to you of the principal amount you invested.

3. A LifeStage Retirement Income Note is not eligible to be insured by the Canada Deposit Insurance Corporation or any other entity.

4. The return, if any, that you receive on your LifeStage Retirement Income Note is based on the performance of the underlying funds. It is not based on a fixed, floating or other specified interest rate. While you will receive the full principal amount you invest in a LifeStage Retirement Income Note if you hold it until maturity, it is possible that you will not receive any return on the amount you deposit with us.

5. A LifeStage Retirement Income Note is not designed to be repaid in full on demand at any time. Other than the regularly scheduled capital distributions that we make to you, you will not be able to withdraw the amount invested in a LifeStage Retirement Income Note until it matures.

6. Capital distributions will reduce the value of the LifeStage Retirement Income Portfolio resulting in the LifeStage Retirement Income Notes having less exposure to the underlying funds. Aggregate fees paid under the LifeStage Retirement Income Note Program will reduce and may eliminate any return you would otherwise have received when your LifeStage Retirement Income Notes mature.

So let’s see if we understand this. BMO will give you back your own money over several years. The Bank will not guarantee any return. You can’t cash in early and it’s unlikely you could sell the note to anyone else – if you could, it would probably be at a deep discount. For all this, BMO will charge you an annual fee of 2.25 per cent. In short, they have guaranteed they will make money. You have no such guarantee.

We’ve gone back a generation, but with a new type of product which is once again being “sold, not bought”. My advice stands: if you don’t understand a security, don’t put money into it. To which I might add another cliché: if it sounds too good to be true, it probably is.

Adapted from an article that originally appeared in Mutual Funds Update, a monthly newsletter that provides advice on fund selection and strategies. For subscription information, click here.