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