What if we told you that you can invest your money in the S&P 500 and you don’t have to worry about losing it? That’s right, if the market goes up, you get to participate in those market gains and yet if the market goes down, you get your initial investment back. This is a structured product known as a Principal Protected Note.
Have you ever been offered such a product by your broker? It sounds too good to be true? It is.
PRINCIPAL PROTECTED NOTES AND HOW THEY WORK
Principal protected notes, or PPNs, are financially engineered by a financial institution and sold to retail customers. It is an investment vehicle that guarantees future payment of the greater of the investor’s initial investment or participation in the underlying market.
Below are two very basic illustrated scenarios of how a principal protected note can be presented:
Scenario 1 demonstrates how the PPN works if the underlying market benchmark (say the SP500 index) has positive performance over the life of the note. The investor makes an initial investment today in a five-year PPN. At maturity, the investor will get back their principal and some amount of return determined by the terms of the PPN contract. In Scenario 2 you have the opposite profile, the market benchmark has gone down from its initial level. In this case, the investor has not participated in the downside and had their initial investment returned at maturity. Conceptually, your principal has been “protected”.
However, PPNs can be very complicated instruments with a variety of options. Differentiating variables found in PPNs:
- Participation Rate – If the market goes up, how much of the performance flows to the investor? There are no limits on participation rates, but traditionally they range from 20% to 80% of the benchmark appreciation.
- Maximum Return – Some PPNs may cap the amount of return an investor can receive.
- Downside Protection – A PPN can offer as much 100% protection of your principal all the way down to 0% in some conditions.
- Benchmark – The PPN can be linked to just about any index, asset, or market indicator.
WHAT MAKES A PRINCIPAL PROTECTED NOTE AN UNWISE INVESTMENT?
The Street can present this product as a very appealing option for most retail customers. Most would think that this investment vehicle is a sure win. But what is not clearly understood are the fees, risks, and time value decay of money inherent in PPNs.
- Fees – Any entity that sells a financial product does not do so out of altruism; they do it to earn a profit. Financially engineering a PPN has manufacturing and maintenance costs. Underwriting fees and management fees are the most common. However, the financial institutions profit margin and your opportunity costs should not be overlooked
- Risk – On the surface, the product as presented seems to remove risk from the decision process. That’s not the case. By purchasing the PPN, you are taking credit risk on the underlying sponsor. Thoughts that this risk is insignificant are misguided. When Lehman Bros. failed in 2008, all their PPN investors immediately became unsecured creditors in a complex bankruptcy. Each PPN has a term, commonly 5 years to maturity. Secondary markets are very fragmented for such products; your investment is essentially illiquid, and you’d incur a significant cost (loss of return, back bid, etc.) if you needed to access your capital before maturity. Depending on how the PPN is structured, investors may incur taxation consequences over the life of the investment.
- Time Value Decay – Simply getting your money back is very simplistic investing; the nature of long term investing is to earn a positive return over time. Protecting your principal is a misnomer; what you are really doing is minimizing your loss by giving up basic return. Most PPNs use market indicators that do not incorporate dividends. Invest in a PPN linked to the S&P 500 and you are giving up the index’s dividend yield that you should be earning. Additionally, inflation, regardless how low, will also rob you of return. Even 1.5% annual inflation rate results in a 7.7% decay in the real value of your investment over 5 years.
Below is a graphic representation of how your investment would look with detrimental factors considered. Take note the illustration does not incorporate liquidity or credit risk.
ARE PPNS APPROPRIATE FOR INVESTORS?
Short answer – NO. A PPN is an example of how “specialists” take advantage of the “uninformed”. Most sophisticated investment advisors, like Atlas Capital, can more cheaply construct a portfolio tailored to the objectives of the client without incurring the inherent costs found in a PPN. These products can easily be replicated in the futures and/or derivatives markets. It’s only natural to be beguiled by a slick presentation of a product claiming to be “new and improved”. But investing is a pretty basic trade, with simple economic tenets. Risk cannot be transferred without cost. Or as your parents may have told you, there is no free lunch.