Training wheels for new investors
When I was in university, my mom worked at a law firm in downtown Edmonton, on Stony Plain Road. One of the lawyer’s wives had a pedal bike that she wasn’t using, and so she offered it to me for $50. It was a good bike, but the tires were white-walled and had sun damage.
Nine years later, Darcy was wandering through Canadian Tire in Wainwright and saw some bike tires in the clearance rack. Turns out they were the exact perfect size for my bike. After nine years and $25 for bike tires and tubes, I rode my bike to work this morning.
My sisters and I learned to ride bikes where we lived west of Stony Plain. The front yard had a good size hill leading down to the driveway, and then a small field after that. My dad brought us to the top of the hill and told us he was going to hang on but it was a lie. Instead, he gave us a push and we had to learn to ride very quickly.
More common in paved areas you’ll see training wheels mounted on the bikes of children eager to learn. It’s a slower way to learn than free-wheeling down a hill towards a gravel driveway, but it’s safer too. Once the kids are reasonably competent and confident, the training wheels come off and they’re good to go.
Training wheels for new investors
If you’re new to investing, it’s okay to use training wheels. You get to practice balancing your portfolio, and you can pedal along with a little bit of speed, getting used to all of the various forces pulling at your centre of gravity.
A principal protected note (PPN) is one way for investors to get training. A PPN is an investment whose performance is linked to another investment (stocks, a mutual fund, an index), but the returns on each side are limited. You’re not going to reach cruising speed, but you’re not going to scrape your knees either.
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PPNs are generally built one of two different ways. The first way, a bond is purchased so that at maturity it will be worth exactly what investors put into the PPN. With today’s low interest rates, the cost of the bond can work out to close to 90% of the overall PPN purchase price. The remaining 10% is then used to purchase a call option on the underlying investment. A call option gives the PPN the right to, but not the obligation, to buy the underlying investment at a specified price. At maturity, if the market value of the underlying investment is higher than the call price, the PPN uses the call to buy the investment at the call price, and then sells immediately to produce a return for the PPN investors. If the market value of the underlying investment is less than the call price, the call expires and the bond portion of the investment – now equal to the original investment in the PPN – is returned to the PPN investors.
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The second way PPNs are structured is similar, except that the principal-protection bond is not purchased right away. At all times throughout its life, the PPN notes the amount of bond required for full principal protection (again, for example, we’ll say initially it’s 90%), but invests the entire amount in the underlying asset. If the underlying asset grows, the investor gets to participate in that growth. If the underlying investment falls below the bond line, a safety mechanism is triggered, the investment is sold and the bond is locked-in. There is no longer any potential for gains for the remainder of the term of the PPN, even if the underlying investment averages a gain over the entire investment period. It may be important to note that this type of structure, while still valid, hasn’t been used much since PPN issuers had to monetize many of them in late 2008/early 2009.
Related article: How to create your own index linked GIC
Investments promising certainty and limited downside risk are increasingly popular with investors who have a reduced tolerance for volatility. They make investors comfortable, and because of that, they’re easy to sell, which makes them good for the investment business. But that doesn’t necessarily mean they’re good for every investor. Every investment has a trade-off, and along with being fairly complex and generally higher-than-average commissions, in the case of PPNs the trade-off is a cap on returns.
Some PPNs limit returns by offering the investor a participation rate (i.e., you only get 50% of gains in the underlying investment), and others impose a hard-cap return (i.e., 15% maximum return) no matter how well the underlying investment performs.
Remember to take off the training wheels
PPNs are a tool, and like any tool, they need to be used properly. For new investors that want a bit of training into how the markets work without any downside exposure, PPNs can make sense. But once you’ve got the feel for riding, you should take the training wheels off your bike. Because like training wheels, long-term use can reinforce poor habits. A long-term bike rider with training wheels may become too reliant on their protection, even when hurdling downhill, and end up surprised and shocked when they wipe out. Just the same, the PPN’s protection is only as good as the creditworthiness of its issuer – something that needs to be considered before any purchase. And secondly, and more importantly, PPNs teach investors that when the markets are down, it’s okay to pull out and ride a bond back to principal protection, which is the exact opposite of what a prudent long-term investor should do. If there is any time to get aggressive, it’s when markets are down. If your bike is leaning, don’t just let the training wheels catch you, throw your weight the other way!
In 2007 the IDA (now IIROC) issued a Due Diligence Guideline which essentially suggested that PPNs are appropriate for an investor with “good” or better investment knowledge, and their risk tolerance should be “medium” or higher. PPNs are useful as a training tool, but they’re not an appropriate long term strategy for a conservative investor. Once you’ve learned to ride a bike, take off the training wheels. They’re just slowing you down. And they look a little silly too.
If you have questions on appropriate long-term investment strategies, or for more information on the habits of a prudent investor, speak to a CERTIFIED FINANCIAL PLANNER® today.