Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
  • T519.880.0888
  • 1.877.517.0888
  • F519.880.9997
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  • Waterloo, Ontario N2L 1T2

The Protection Racket

February 28, 2014 - 0 comments

The idea of Principal Protected Notes is alluring, but can they deliver?

How would you like to invest in the stock market where you get to keep the upside and get all your money back if the market goes down? Sound perfect? Then read on.

Principal Protected Notes are investments issued by Canadian banks that appeal to the inner “free lunch” in all of us. Understanding these investments is a useful tutorial in some key investing concepts.

We will use for our example, a Protected Note from CIBC Investments called the CIBC Morningstar Wide Moat Growth Deposit Note, Series 8. We chose this because it is representative of the genre and was fairly recently issued but no longer available.

Here is how it works. An investor gets exposure to a basket of 10 U.S. stocks. If after 6 years the value of the basket has fallen, the investor’s initial investment is returned. If the basket increases in value over the 6 years then the investor gets the initial investment back plus the investment growth up to a maximum of 72%. If you are wondering where the Wide Moat fits in, we will come to that later.

At first blush, this seems great, who wouldn’t be willing to give up just over a quarter of the potential upside to eliminate the risk of a loss?

The devil is in the details.

First, the investor’s capital is tied up for 6 years. (CIBC may offer a secondary market in the Notes, but there is no guarantee of a buyer and they are typically sold at a deep discount). As an alternative to the CIBC Note an investor could invest her money in a secure 6 year bond. We will take as our benchmark an Ontario Hydro One 6-year investment grade bond, with an annual return of 2.71%. This is close to a risk free investment from an issuer with a similar credit rating to CIBC, so an investor in the CIBC Note would require a return in excess of this. An annual return of 2.71% equates to a total return over 6 years of 17.4%. In other words, an investor should reasonably expect more than 17.4% return from the CIBC Note.

Secondly, we have to consider the risk associated with investing in a basket of only 10 stocks, especially when the potential upside is limited to a 72% gain. A common reaction is to say that this is no big deal – owning 10 stocks, in equal weight, means that there is no more than 10% of the portfolio in each stock, which seems to offer reasonable protection against one stock wiping out.

To test this intuition we started with the performance of a basket of the largest 500 U.S. stocks as represented by the S&P 5001. Our long term estimate of the future return of the S&P 500 is an annual return of 7% (2% inflation, plus a 5% equity premium) with a standard deviation of 14.46% (based on historic data). However, with strong recent performance from U.S. equities they now look slightly expensive compared to historic valuations. Higher valuations lead to lower future returns and our estimate of short term expected returns is reduced to 6.1%. The CIBC Note only tracks the price performance of the basket of ten stocks, ignoring the dividends. The dividend yield from the S&P 500 is 2.1% so the expected price gain is 6.1-2.1= 4.0%.

Next we have to address the impact of having only ten stocks on the risk (as measured by standard deviation) to the portfolio returns. Based on a widely cited study2, we estimate the ten stock portfolio is 24% riskier than the S&P 500. We illustrate this graphically in Figure 1 showing the distribution of the cumulative returns for the S&P 500 and the ten stock portfolio after 6 years. A ten stock portfolio has fatter tails which implies that both higher returns and lower returns are more likely. The vertical line reminds us that the CIBC note has a cap on the maximum return. Because more of the 10 stock returns fall to the right of this cap, and the portfolio has more negative returns, the average return of the 10 stock portfolio is reduced. We calculated 3 the average return from the ten stock portfolio to be 18.33% over the six years.

The final piece in the puzzle is to note that there is a 2.50% up front sales charge for the CIBC Note. Thus for every $100 paid by the investor, only $97.50 is invested.

Summarizing, based on our analysis, the expected return from the CIBC Note over six year is 17.9% (18.33% x 0.975) compared with a an investment grade bond returning 17.4%.

An equivalent offer would be to choose between investments with:

  1. A guaranteed return of 17.4%
  2. A 50% chance of a return less than 17.9% or a 50% chance of a return greater than 17.9% (but less than 72%)

Most investors are at least slightly risk averse and would pass on the CIBC Note. Moreover, we would contend that given the room for error in some of our estimates the excess return from the CIBC Note, on a risk adjusted basis, is effectively zero. There is no free lunch.

And that Wide Moat?

If the CIBC Note has a volatility penalty because of being restricted to only ten stocks why did they not simply offer to track one of the readily available S&P 500 index ETFs? By our estimation investors would have enjoyed an additional 3.4%3 return. The simple answer is that CIBC would have lost money on every Note they sold. To distract from this Note designers often try to give the impression that there is something special about the ten selected stocks (other than that there are only 10). In this case CIBC have drawn on the work of Morningstar, a research firm, who have helpfully come up with a set of criteria that assesses how good a company is at keeping competitors at bay – such companies have been described (by Warren Buffet, no less) as having a wide economic moat. Do companies that have wide economic moats enjoy higher future returns? There is not enough data to know but it is a great piece of marketing ju-jitsu. We do know that the financial industry is forever trying to pre-select stocks with special properties that out-perform the market and that most do not stand the test of time.



  1. Because the CIBC note disregards dividends and only looks at price performance of the basket of stocks we use the S&P 500 performance, excluding dividends.
  2. E. J. Elton and M. J. Gruber, "Risk Reduction and Portfolio Size: An Analytic Solution," Journal of Business 50 (October 1977), pp. 415-37
  3. We simulated over 65,000 instances of the six year return from a ten stock portfolio assuming a 24% higher standard deviation for the portfolio compared to the S&P 500.
  4. This compares the S&P 500 and the ten stock portfolio with the same 72% performance cap.
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