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The
returns of PPNs are generally linked to another asset of investment - usually
stock indexes, but they can also be linked to commodities, mutual funds, or
hedge funds. What most PPNs do is
invest most of your money (usually about 60-70%) in a very safe investment such
as a money market fund. This will grow
to be equal to your original investment after a certain number of years. The rest of the money is placed in the
riskier asset, which provides the upside portion of the investment. In a way, it is similar to a conservative
balanced fund.
The
first downside with PPNs is their cost.
The actual cost structure of many PPNs is rather vague, and there can be
many hidden layers of costs that are not advertised. First, there is the expense for running the actual note. Then, for PPNs that are based on another investment
product, there is the MER to be paid to the manager of the underlying
asset. On top of this, there can
sometimes be generous trailers paid to the advisors selling the PPN. Often times, these costs are not outlined in
the prospectuses of the PPNs
Most
PPNs also require the investor to hold the product until maturity, which is
usually eight years, but can vary anywhere from five to ten years. For most investors, locking into an
investment for long time periods is seldom a good thing. Anyone who has invested in labour sponsored
funds or faced the early redemption fees for DSC funds would attest to
that. Advisors and investment managers
tend to benefit the most from this, as they have assets locked in for a longer
period of time.
Another
aspect of PPNs that not everyone recognizes is that the capital protection they
provide is rarely necessary. Assuming
you hold an 8-year PPN until maturity, the chance that your investment
(especially if it is a stock index) will be in the red after those eight years
is very rare. We looked at all of the
rolling 8-year returns of the S&P 500 going back 50 years to see how often
this 8-year return was negative. The
only investors who would have seen a loss would have been those who invested in
the late 1960s-early 1970s, or those who entered into the market during the
last days of the tech bubble. For the
TSX and its almost 30 years of history, it has yet to see a negative 8-year
return. The argument for capital
protection only becomes more compelling as the underlying asset increases in
risk, such as commodities or emerging markets.
The most obvious example would be gold, as it took over a quarter
century to recover to its previous highs.
Although all PPNs have their subtle
differences, the majority of them can be classified as paying for protection
you may rarely use.
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