Steadyhand’s Tom Bradley: buyer beware.Laura Leyshon/The Globe and Mail
Investors may have come across a product that bills itself as the perfect investment: You can play the stock market and potentially earn higher returns than with fixed-income securities … without risking your capital.
But buyer beware: Experts are critical.
Sometimes called market-linked GICs, these are derivative instruments offered by banks.
Tom Bradley is one critic. "They make my blood boil," Mr. Bradley says in a recent blog titled, "No dividends, no compounding … no deal." Mr. Bradley is president and co-founder of Vancouver-based Steadyhand Investment Funds Inc., a low-fee mutual fund firm and an advocate of good, clear investment reporting.
"These products are an embarrassment to the wealth management industry," Mr. Bradley says, because they prey on the least knowledgeable investors.
The products do address people's hopes and fears: They hope to make a little money if they can, but they fear losing it even more.
"Are they safe? Yes," says Dan Hallett, vice-president and principal of Oakville, Ont.-based HighView Financial Group. "Are they worth investing in? I have not found one yet that I think is worthwhile."
Despite the criticism, holdings of these products, sometimes called equity-linked structured notes, have grown to $36-billion as of Dec. 31 from $4.9-billion in 2003 in Canada, according to Investor Economics. That pales in comparison to the market for fixed-term deposits of $485-billion.
Structured notes are complex and their cost is difficult to calculate because of hidden fees – facts that have caught the eye of Canadian securities regulators. Regulators are prodding the banking industry to improve its disclosure because the issuer's profit margin is embedded in the offering price of the notes. At least one financial institution, ATB Financial, formerly the Alberta Treasury Branches, has stopped selling the products entirely because of their complexity, lack of transparency and lack of liquidity.
The problem, Mr. Bradley says, is that fees are high and the risk-reward is stacked heavily in the banks' favour. "Most of the risk falls to the client (the potential of no return), while most of the reward goes to the bank – the return formula doesn't include dividends and the upside potential is capped."
In an interview, Mr. Bradley says investors could do better simply by building a conservative, balanced portfolio invested for the long term. Among other things, that allows investors to take advantage of dividends. Whereas issuers of index-linked notes "quietly strip them out. That's where they get part of their profit," he says.
And when comparing returns, Mr. Bradley cautions investors about advertised rates. The bank may advertise a 9-per-cent return, but the return is cumulative over five years, for example.
Other than a balanced portfolio, investors have alternatives, including a "homemade option" put forward by Dan Bortolotti of the Canadian Couch Potato blog and an investment adviser at PWL Capital Inc. in Toronto. Say you have $50,000 to invest. Start with a strip bond or zero coupon bond, using the website's spreadsheet to find its present value. With a 2-per-cent yield, the present value of a six-year, $50,000 zero-coupon bond would be $44,399. Buy a strip bond in that amount and invest the balance of $5,601 in a large-cap equity exchange-traded fund.
"Now, unless your bond defaults, you are guaranteed to have $50,000 in six years, plus some additional return that is tied to the performance of large-cap Canadian stocks," the Canadian Couch Potato blog says. "But unlike the structured note, there is no limit on that potential upside."
"That's an elegant solution," Mr. Bradley says of the strategy. "My solution would be a very conservative, balanced fund, one that is tilted heavily toward fixed income, such as the Steadyhand Income Fund. The fund has about 75 per cent bonds and 25 per cent dividend-paying stocks and REITs."
Says Mr. Bradley in a recent blog: "It's a good time to increase exposure to stocks, but not in a product that strips out the dividends, limits the upside … and doesn't allow holders to benefit from the eighth wonder of the world, the power of compounding."
Approach with caution
Kurt Rosentreter, a senior financial adviser at Manulife Securities Inc., has some other investments on his list of things investors can probably do without.
Initial public offerings: He doesn't mean IPOs of common names such as Google or Tim Hortons, but rather new issues of companies that are merely closed-end funds with words such as dividend and income in their names. "There's a vast array of 'frankenproducts,' manufactured closed-end trusts and specialty products. They have good sales pitches, touting big dividends and a limited-time offer," Mr Rosentreter says. Investors would be better off buying the stocks directly, he adds.
Segregated funds: These are insurance-company contracts that "look and smell like mutual funds" with guarantees of principal, Mr. Rosentreter says. "They have among the highest fees in the country, some topping 4 per cent a year." Guarantees are limited; for example the guarantee might state that you will get back at least 75 per cent of your principal after 15 years.
Anything you don't understand: At a first meeting with a new client, Mr. Rosentreter asks them to spread out their statements on the table and explain, before they even start discussing strategy, what all their products are. "Most people don't have a clue."