Protection racket: principal-protected notes
"Getting Started" by Duncan Hood

From the February/March 2006 issue of Moneysense.

If you could invest in hedge funds with no risk of losing your money, would you do so? What if I told you that tons of people already have? They're buying principal-protected notes (PPNs for short) that allow investors with as little as $500 to invest in hedge funds that are normally restricted to the wealthy. What makes this especially attractive is that PPNs guarantee your initial investment, so it's impossible to lose money if you hold the notes to maturity. Thanks to this no-lose proposition, PPNs are selling like umbrellas in Vancouver and now account for half of the $14 billion or so that individual investors have in hedge funds in Canada.

In short, PPNs have been a remarkable marketing success — but the problem is that they contain some serious flaws. They work beautifully for the folks who manage and sell them, not so well for you.

Watered-down returns

The first problem with PPNs is that the principal protection doesn't work the way you might think. When you buy a PPN, it doesn't invest all your money in hedge funds (or whatever investment the note is linked to), then jump in to rescue you if things go bad. Instead, the PPN takes about $70 of every $100 you invest and puts it in low-risk investments that will grow to $100 by the time the note matures in five to 11 years. It's that money that will pay back your initial principal if anything goes wrong, so you're essentially covering any potential losses with your own money.

This little maneuver puts a big crimp in the returns you can expect. Because only $30 out of $100 is actually invested in hedge funds, that $30 will have to produce spectacular returns just to deliver so-so results for your overall investment. For instance, if your note is linked to a hedge fund with a 2% fee that delivers a respectable average annual return of 10% before fees over a 10-year span, your annual return will only be a measly 5%.

Fees-a-plenty

PPNs aren't regulated in the same manner that mutual funds are. The person who sells you the PPN can withhold some important information — like how much you're paying in fees.

The total bill can be staggering. At a Senate Committee meeting last June looking at how to protect hedge fund investors, Louis Piergeti, vice-president of financial compliance with the Investment Dealers Association of Canada (IDA), rhymed off a laundry list of fees that would make your hair stand on end. Those fees include commissions for the guy who sells you the note (up to 5% right off the top), fees to set up the note, annual management fees (ranging from 2% to 3%), performance fees (up to 20% of the returns above a benchmark), swap fees, prime brokerage commissions and the fees charged by the hedge funds themselves.

Locked into low growth?

As you might imagine, those fees will further dampen your performance, which brings us to the real risk posed by PPNs — the risk that you will lock up your money for a decade for nothing. "There is no guarantee that the investor will earn any positive returns on the original investment," wrote the IDA in an analysis it published last May. The report went on to note that "the risk that investments locked in for as long as 10 years will earn a zero return is no small risk to a retail investor." No kidding.

The more you look at PPNs, the more you're struck by their limitations. In the end, I wouldn't avoid PPNs just because they're largely unregulated or because their "Information Statements" are so poorly written that even Glorianne Stromberg, a securities lawyer and former commissioner at the Ontario Securities Commission, admits she can't understand them. I would avoid them because you can find better places for your money.

If you're determined to protect your principal, you could always create your own PPN by investing 70% of your money in safe bonds or GICs and investing the other 30% in higher-risk investments. You'll save yourself a whole layer of fees and you'll have a lot more flexibility.

Even if you don't mind locking up your money for a decade, I think the whole "principal protection"approach unnecessarily limits your potential growth, no matter how you do it. A better way to handle risk is to be up front about how much risk you want to take on, then choose simple, low-cost investments that fit. "People spend all this time and effort chasing after returns, and they don't end up with anything to show for it," says Stromberg. "If they'd just invested in a plain-vanilla low-cost balanced mutual fund to begin with, they'd be ahead of the game."