10/22/2011 09:03 EDT | Updated 12/22/2011 05:12 EST

How Much Risk Are You Willing to Take?

While Principal Protected Notes become more enticing when in we're engulfed in an environment of uncertainty, they are still not widely understood. The key flaw in these products is that they blur what is the most fundamental decision an investor must make -- whether or not to take risk and, if so, how much?

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The other day I spoke to a reporter about the merits of so-called capital preservation tools which enable investors to protect their assets, while placing bets on the outcome of riskier markets such as stocks and commodities. Most popular of these is the Principal Protected Note, or PPN. A variant of this vehicle is the index-linked GIC. Both offer the investor safety in the form of a delivering back the original principal, with the opportunity to enhance return on that principal beyond a comparable maturity 'risk-free' investment. While these products become more enticing when in we're engulfed in an environment of uncertainty, such as today, they are still not widely understood. The key flaw in these products is that they blur what is the most fundamental decision an investor must make -- whether or not to take risk and, if so, how much? They also limit an individual's flexibility in responding to risk.

Let's look at the index-linked GIC. While it might seem attractive to hold something where principal is guaranteed (which isn't the same as saying that guarantee is insured), while offering a market-related improvement to a normal GIC interest rate; the guaranteed value is only effective at maturity. It still comes as a surprise to many investors that the guarantee of a regular GIC only applies to the day the note matures, since in all the days in between the purchase and the end date the value of the GIC is marked to market like any other fixed income instrument. Cash in or break a five-year GIC before maturity may not give you back the notional value of the note if interest rates have climbed in that intervening period. Likewise, the return of an index-linked GIC is provided only on maturity. If the market the GIC is linked to is up at maturity (or just prior to depending on the product) relative to the purchase date, a percentage return based on the movement in the market index is paid, up to a maximum -- regardless of how much the market improved. However, if the market goes up during some stage of the note, but then falls towards maturity, the return diminishes; or it disappears entirely when the market index is below that which existed at the time of purchase. In other words, all the investor is left with is his or her capital and nothing to show for it. In inflation-adjusted terms, the investor will have lost money. That may not seem bad if the overriding objective was simply protection of capital, but a higher return may have been possible on a more traditional fixed income instrument (a corporate bond or even a plain old GIC).

If we treated the index-linked GIC for what it really is -- a rigid, built-in balanced fund -- it would be far better for the investor to have control of the risk embedded in the note. In other words, if a market strengthened over some period during the length of the note, then an investor may have wished to lock in that performance and bank the enhanced return by selling the market part of the note. This is easier demonstrated with the PPN, which is effectively made up of two things -- a zero coupon bond and some risk attachment. Let's assume we have $100 to invest and use part of this, say $80, to purchase a zero coupon bond which matures at $100 in five years, with the rest invested in the market. We could then leave the zero coupon bond investment in place and sell the market-related part when a return hit a desired threshold. By blending the two, this option is taken away. Worse still, the note is also embedded with a myriad of fees that come from 'structuring' of the note. Again, if the objective of the client is to have zero risk, this note is inappropriate.

If the investor desires risk, and knows how much risk to take, far better to either create his or own PPN, or better still, simply create a balanced portfolio of securities. This may very well be a portfolio made up of low-risk (federal or provincial) zero coupon bonds, with the remainder invested in a diversified portfolio of equities or commodity-linked exchange traded funds (ETFs). If the non-fixed income segment of the portfolio increases in value beyond the desired risk limit, profits are taken and re-invested back into fixed income. What if markets fade in the intervening period? With either the PPN or index-linked GIC, the investor is forced to wait for markets to recover and strengthen which, in the current climate, could be an agonizing wait. In a balanced portfolio compromised of bonds, it is quite likely that this segment will see an appreciation in value as riskier assets fall. The investor can then take profits on those bonds and either re-invest in money market or redeploy to the riskier assets to maintain the desired balance. Even with the trading fees incurred in this strategy, the improved flexibility makes it superior to a locked-in approach taken with the PPN or index-linked GIC. In a fee-based portfolio management platform, the benefits are even greater in my opinion. The bottom line is that when products are sold on the basis of being 'simple' they may neither be that simple nor better than the really simple approach taken with a calculated risk balanced portfolio.