Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA

Associate Portfolio Manager
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  • Ottawa, Ontario K1S 2E1

Principal Protected Notes vs. a Balanced Portfolio

Principal Protected Notes are investment vehicles governed by complex contracts that are not regulated or reviewed by any securities commission. In most cases, the contract offers investors the opportunity to participate in a percentage of the price increase of an underlying group of assets (stocks, bonds, an index) over a set period of time while being guaranteed to receive their initial investment back at the maturity date. The pitch is that this is an opportunity for investors to participate in the potential upside of some assets, with none of the downside. This is a great story. It's so good, in fact, that Tony Robbins advised his millions of readers around the world to take advantage of this type of investment vehicle. There is, however, a problem with the logic: volatility is part of investing. Risk and return are always related. Removing risk from an investment vehicle inevitably reduces expected return. Being shielded from the downside seems like a great benefit, but PPNs tend to have maturities longer than five years, and throughout market history there have been very few periods longer than 5 years with significant negative returns. This fact should diminish the attractiveness of PPNs' principal guarantees in the eyes of a rational investor.

Quantifying the attractiveness of PPNs through analysis is possible with a simulation comparing the experience of an investor holding a balanced portfolio of globally diversified, low-cost index funds with an investor holding PPNs. For the sampling, all available data on previously issued Scotiabank PPNs with maturities longer than 5 years was used. The balanced portfolio consisted of 50% DFA Global Equity Fund* and 50% DFA 5 Year Global Fixed Income Fund. The total sample consisted of 35 PPN issues spanning various time periods between March 2006 and January 2015. Trials were run comparing each PPN to the balanced fund over the time period that the PPN issue was outstanding. There is time period bias in the data sample which could be addressed in later research.

In the sample, 35% of the PPN issues returned 0% at maturity, meaning that the investor only received their initial capital back due to the underlying asset having exhibited negative performance. The balanced portfolio never once produced a return of 0% or lower. In fact, the balanced portfolio produced an annualized return lower than 2% in only 3 of the 35 sample periods. In 86% of the trials, the balanced portfolio outperformed the PPN at the PPN’s maturity. The highest return in the sample came from the BNS Commodity Linked Deposit Note, S2 which had an annualized return of 11.41% over 5.5 years; this positive performance came primarily from the gold bull market during the life of this particular PPN issue, which nobody could have predicted ahead of time. The PPNs returned an average of 1.62%, compared to 4.05% for the balanced portfolio.

Seeing this data, it seems obvious that any rational investor would select a balanced portfolio of index funds over a PPN issue. However, investors are not rational and the returns do not tell the whole story. In 71% of the trials, the balanced portfolio was down more than 20% in one year of the sample period. In 94% of the trials, the balanced portfolio was down more than 10% in one year, and in 100% of the trials, the balanced portfolio had a negative return in at least one year. At the end of 5 years it is easy to see which investment vehicle was ultimately better for investors, but many investors are deterred by the potential for negative returns; they would rather accept lower long-term returns in favor of having their capital guaranteed – this is a reflection of emotional, irrational behaviour. Financial institutions understand that investors are emotional and irrational, and have created PPNs and similar products to profit from their tendencies. If investors can remain rational, they will not fall prey to PPNs or other structured products.

 *  Prior to October, 2011 the DFA Global Equity Index adjusted for a .5% MER was used for performance data as the fund was not operational.

Source: Performance data from Dimensional Returns 2.0


By: Ben Felix | 0 comments

Structured Notes are Behaviourally Satisfying and Rationally Harmful

A structured note/structured product/equity-linked note is a financial derivative with a return at maturity that is linked to some underlying asset or group of assets. The linked asset tends to be some stocks or a stock market index. Structured products are popular because they play to investors’ behavioural biases, and they are profitable for financial institutions. These products are notoriously complex.

The product is effectively an unsecured bond that limits exposure to losses while being positioned to take part in potential gains. Structured notes are the product of investor fear, and tend to become very popular in periods of market volatility when a high potential yield and a principle guarantee become very attractive. Research has shown that structured products have not gained popularity due to rational analysis by investors, but instead due to the associated behavioural factors that they play to.

These products tend to be marketed to retail investors who have a limited understanding of the products’ underlying structure; this is a problem that is exacerbated by an enormous lack of regulation around their selling and marketing practices.

The rational role of structured products for a retail investor is questionable at best when modern portfolio theory is consulted; an investor should be able to maximize utility for any desired risk-return characteristics using a mix between the market portfolio (broad market ETFs), and the risk-free asset (GICs or short-term fixed income).

The main problems that structured products pose for investors include mind-numbing complexity, a cap on upside potential, an upfront sales commission (the investment is immediately reduced by the amount of commission), lack of liquidity (there is a limited secondary market, unless sold at a deep discount), and the opportunity cost of not investing in a traditional low-cost, risk-appropriate portfolio over the same time period.

In any case, each structured note is very different. Due to their complexity, in-depth analysis and understanding must be applied in every case that they are to be considered – though they should likely not be considered by a rational investor.

By: Ben Felix | 0 comments

What Investors Need to Know About Managing Risk

“Investors love risk when stocks skyrocket, and hate it when they tank.” It is commonly accepted that there is risk involved in investing, but investors do not always know how to define it. In a recent white paper, PWL’s Raymond Kerzerho and Dan Bortolotti set out to help investors understand what risk is, and how it can be managed through a disciplined approach. In reality, the vast majority of investors choose to take risk management shortcuts like principal protected notes, hedge funds and guaranteed income products. These products “are often guilty of implying that you can achieve equity-like returns with bond or GIC-like risk,” which can be harmful to the long-term success of an investor.

Risk can be broken down into two broad categories: Economic risks, and Behavioural risks.

Economic risks are risks that investors have no control over, though they can be mitigated through thoughtful portfolio construction.  Economic risks include recessions, high inflation, and wars and political turmoil. The severe decline in stock prices during the Great Depression, negative bond returns after inflation from 1950-1980 in the US, and investors losing their assets due to the Russian revolution of 1917 are cited as respective examples for the economic risks that investors are exposed to.

Behavioural risks are in the investor’s control, but tend to be far more harmful than economic risks. “Even during periods of economic prosperity and booming markets, many investors experience low returns because of destructive behaviour.” Behavioural risks include concentration, market timing, and active trading. Investing in one company that is touted as the next Google, sitting in cash through a period when equities rise sharply, and doing analysis to identify mis-priced securities are given as respective examples of common behavioural mistakes.

There are steps that an investor can take to manage both economic and behavioural risks: Start with an appropriate asset mix – and stick to it, write an investment policy statement, keep your bonds safe, embrace only compensated risks, invest in entire asset classes, and review your portfolio. Following these guidelines positions even the most emotional investor to behave rationally.

Read the full PWL white paper, Managing Risk, here.

By: Ben Felix | 0 comments

Preferred Shares: Not worth the risk in non-taxable accounts

Investors looking for yield in a low-interest rate environment will often turn to preferred shares. Preferred shares can be a good tool for taxable investors due to the Canadian Dividend Tax Credit, but for non-taxable investors they are significantly less attractive. In situations where tax efficiency is not a benefit, preferred shares pose risks that are not worth taking.

Like bonds, preferred shares are exposed to credit risk. An important difference between the two types of securities is that in the event of a bankruptcy/reorganization, preferred shareholders are the last to be paid after all creditors. Preferred shares also have a higher risk of default than bonds from the same issuer; this is because firms are generally allowed to default on their preferred dividend without defaulting on their bond interest payments. In the event of a general payment default, preferred shares are unlikely to recover any of their initial investment, whereas bondholders typically recover 20 to 60 cents on the dollar. These factors make the credit risk associated with preferred shares much higher than that of bonds.

Preferred shares can also be exposed to redemption risk; they are often redeemable at the option of the issuer. This means that the issuer can choose to buy the shares back from investors at a fixed price according to a pre-set schedule. The result of this redemption option is that if interest rates go up, you are stuck with your relatively low dividend preferred shares, and if rates go down you won’t benefit much from price appreciation. The price of a redeemable preferred share does not rise on falling interest rates like that of a bond because the market knows that if the price rises past a certain point, the company will take the preferred share back at the predetermined price.

To justify their level of risk, preferred shares would need to offer significant return. The S&P/TSX Preferred Share Index, as of Dec 31 2014, has returned 4.6% over 5 years and 2.9% over 10 years. Preferred shares do not offer sufficient return to make them an attractive option for non-taxable investors.

By: Ben Felix & Raymond Kérzerho | 2 comments