Canadian MoneySaver  http://www.canadianmoneysaver.ca FEBRUARY 2009

Investment Products to Avoid (Part 2)
Gail Bebee

What a difference a few months make! As I completed part one of this article at the end of July 2008 the TSX Composite Index closed at 13,593. At the end of November, the Index stood at 9271 with stock markets around the world facing similar declines. Down over 30% in 4 months and gyrating up and down hundreds of points from day to day! 

The financial crisis of confidence associated with this steep stock market decline accentuates the importance of astute investment choices.  In my previous article I discussed labour sponsored investment funds, collectibles, currency hedging products, guaranteed minimum withdrawal benefit products, options and hedge funds as investments that I don’t buy. In this article I’ll talk about six more investment products I don’t buy, which I think most, if not all, retail investors would be wise to avoid.

Principal-Protected Notes

Principal-protected notes PPNs) are fixed-income products with returns linked to the performance of a specific equity asset, such as a mutual fund, groups of stocks or a stock index. They are marketed as “have your cake and eat it too” investments – the return of the original investment is guaranteed at maturity (usually 6-10 years) and the buyer gets the juicy returns of an equity.

To achieve the advertised returns, the notes are structured into two parts, a guaranteed investment certificate and a higher risk derivative investment linked to the returns of the underlying asset. The calculation of the actual return the note provides is complicated. In addition, there may be upper limits placed on the returns offered, so if the underlying asset performance is outstanding, the note holder will only receive part of these profits.

There are substantial administrative costs associated PPNs, notes given their complex structure. Plus, there are commissions and ongoing trailer fees to pay to advisors who sell the notes.

PPNs have other negatives.

• Your initial investment is effectively locked up for the term of the note. It is difficult to take the money out before maturity and there may be early redemption fees to do so.
• The guarantee of return of capital only applies if the note is held to maturity and it true worth depends on the financial health of the issuer.
• The returns, if any, on notes held to maturity are taxed as interest income, which carries the higher tax rate than capital gain or dividend income.
• Even if you get your capital back, you have made zero return, effectively losing money at the rate of inflation.

The recent financial market chaos has unearthed yet another negative aspect of some of these notes i.e. the little-known “protection event” clause.  If the equity portion of the note goes down substantially near the beginning of the note’s term, a “protection event” could be declared. In such a case, the equity investment is cashed in and invested in a bond to make sure the issuer will be able to return your initial capital at maturity. After this happens, all you’ll ever get back at maturity is little more than your capital, even if the equity portion rebounds in value.

I think investors are better off buying basic fixed-income products if they want guaranteed returns and buying stocks or an exchange-traded fund for the higher long-term returns that equities offer.

Private Equity Firms

Private equity firms are in the business of raising money privately, that is, they do not use public stock exchanges. The best known of such firms are leveraged buyout specialists. These companies typically operate by buying up all the shares in a public company and taking it private. Often, the purchase is made largely with borrowed money and the target company is used as collateral. The private equity firm overhauls the company, often laying off workers and selling profitable divisions. After extracting as much money as possible from the company, it then sells the business by issuing shares of the revamped company on a public stock exchange.

It is possible to buy shares in some private equity firms, such as Fortress Investment Group LLC and Blackstone Group, on public stock exchanges. Talk about a contradiction in terms!

In today’s failing economy, many private equity firms are struggling to survive e.g. in early December, 2008, Fortress shares were down about 90% from their 52 week high.  This has reconfirmed my opinion that private equity investing is extremely risky and retail investors should avoid this asset class.

Resource Limited Partnerships

Resource limited partnerships are “flow-through” shares in resource companies that take advantage of the Canadian government’s tax incentives which encourage investors to finance the very risky business of resource exploration. The gains/losses of the resource company flow through to shareholders and are taxed in their hands. These shares are very high-risk investments and are usually bought for the tax losses they generate.

Split Share Corporations

Split share corporations buy common shares of one or more companies (often an industry sector such as banks) and then issue two classes of shares with very different risk profiles.

• Preferred Shares. Preferred shares generate fixed, cumulative dividends and return the original investment at a specified date. The risk of loss of the initial investment is low and there is a steady stream of dividends.
• Capital Shares. The return from these shares is variable and is based on capital gains (or losses), and any increases/decreases in the dividends paid by the common shares of the companies held. Because of the way these shares are structured, the capital gains and losses are magnified compared to the underlying stock.

Like mutual funds, the split share corporation charges ongoing fees on the value of the assets. You could buy a company’s preferred shares directly and avoid these ongoing fees.  I don’t like the capital shares because of the fees and their ability to magnify losses.

Initial Public Offerings

When a company goes to the stock market for the first time to raise money, they sell stocks in an initial public offering (IPO). If the company is a great investment, all the IPO shares will be sold to large institutional investors and preferred customers of stockbrokers. Individual investors are only able to buy the stock once it trades on the stock exchange, likely at a much higher price, as occurred with the Tim Horton’s IPO in 2005.

A 2003 Industry Canada study concluded that, in general, IPO shares suffer from abnormally poor performance over the first 3 to 5 years following the IPO. (Cécile Carpentier, Maher Kooli and Jean-Marc Suret. “Initial Public Offerings: Status, Flaws and Dysfunctions”, SME Financing Data Initiative, Government of Canada, 2003).

Given the foregoing, I think that individual investors should take a pass on most IPOs and wait a few years to see if the company will survive before buying the stock.

High-Fee Money Market Funds

Money market funds are mutual funds which are generally a safe place to park money short term. You trade a low return rate for safety of your capital which is normally invested in conservative fixed income products like T-bills and government bonds.  In today’s low interest rate environment, there’s not much profit after the fund’s Management Expense Ratio (MER) is subtracted.

To illustrate the impact of MERs on return rates, I ran a screen at globeinvestor.com for open-ended money market funds with a 3 star or higher rating and a $500 minimum investment (data to October 31, 2008). I calculated the correlation between the MER and the 1-year and 3- year return rates. For the 14 funds with a 1-year return rate, the correlation coefficient was -0.84. The correlation was -0.95 for the 11 funds with 3-year return data. (A value of -1.00 would mean that MER and return rate were perfectly inversely correlated). This suggests that for similar money market funds, the fund with the lowest MER usually produces the highest return rate. That’s why I avoid high MER mutual funds. 

In Summary

The above investment products to avoid fit with the theme identified in part one of this series: retail investors should avoid high risk products and those which charge investors hefty fees.  I believe that investing in carefully chosen stocks, investment-grade fixed income products, mutual funds, exchange-traded funds, and real estate offer a better risk-reward proposition for retail investors.

Gail Bebee, B.Sc., M.Eng., Author of “No Hype - The Straight Goods on Investing Your Money” Toronto, ON (416-733-0221), gbebee@nohypeinvesting.com , www.nohypeinvesting.com