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Today's great investing paradox is how an expensive and complicated class of zero-risk investments got so popular in a time of overflowing stock market returns.

Principal-protected notes, index-linked GICs and segregated funds with guaranteed-minimum-withdrawal options add instant bulletproofing to your investments. The cost of this protection against losing money can be extremely high, and yet these products are selling like crazy.

Assets in principal-protected notes have grown to about $14-billion from next to nothing in 1999, while the number of issues now exceeds 600. Manulife Financial introduced its Income Plus guaranteed retirement income product last October and has already attracted $1.5-billion in assets and the interest of at least one competitor, Sun Life Financial, which has just introduced SunWise Elite Plus.

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Security sells these days, even as the S&P/TSX composite index has risen a total 85 per cent in the past five years (this week's decline included). What gives?

Put it down to the essentially conservative nature of Canadian investors.

"They've enjoyed this unusually robust period for the markets and they're looking to tie things down," said Ottawa-based financial industry consultant Gordon Powers. "They're old enough to remember what happened in 2000 or 1987, and they're not anxious to be in the same position again."

Anything that PPNs, index-linked guaranteed investment certificates and segregated funds can do, a savvy investor or adviser can do better and cheaper through conservative portfolio building.

Then again, we're in a society where people are willing to pay more and get less if it adds simplicity and convenience to their lives. If you want to take that approach in your portfolio, here are some things to consider.

1. Capital-protected investments are calibrated to make money for the issuer, not necessarily the investor.

Bank of Montreal introduced some new index-linked GICs this week that clearly show how lucrative these investments can be for issuers, even while providing a guarantee against losing money. The BMO GICs allow buyers to invest in various baskets of stocks and have terms of three or four years.

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At issue are the limits on how much money investors are allowed to make.

Take the new BMO Select GIC, for example. It offers exposure to the S&P/TSX banks index and has a 3.5-year term. Returns are capped at 30 per cent, which on a $1,000 investment would give you a maximum of $1,300 on maturity, or 7.8 per cent on a compound average annual basis.

You can look at this GIC as a risk-free way of investing in bank stocks with the potential to at best make as much as three percentage points more than a five-year GIC pays right now.

Or, you can surmise that bank stocks are such good, consistent performers that BMO believes it's possible to hand GIC holders a 7.8-per-cent return and still have lots of money left over to build in a solid profit.

In fact, the S&P/TSX capped financial index (bank-dominated, but with insurers and other financial players as well) has lost money only five times in the past 19 years and has delivered a compound average annual return of 12.2 per cent. That's 4.4 percentage points more than the best possible outcome from the BMO Select GIC.

We haven't even talked here about the dividends that bank stocks pay. The average dividend yield for the Big Six banks is about 3.4 per cent, which means BMO could pay out close to half the maximum gains on its Select GIC using dividends alone.

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2. Capital-protected investments are expensive to own.

The BMO index-linked GICs show how people can pay for capital protection by forgoing significant upside potential in the underlying investments. Another way that investors pay for zero risk of losing money is through management fees that bite deeply into returns.

This brings us to SunWise Elite Plus, which is a hybrid insurance/mutual fund product for retirement planning that is generically known as a guaranteed-minimum-withdrawal benefit.

With SunWise Elite Plus, you invest in a portfolio of segregated funds and receive a guarantee that you will be able to annually withdraw as much as 5 per cent of your invested capital for 20 years. If you leave your money untouched for 10 years after making your initial investment, you can adjust your annual withdrawal rate to a guaranteed 7.5 per cent.

The upside of a product like this is you eliminate the risk of retiring into a bear market that rips, let's say, 20 per cent off the value of the stocks and equity funds in your retirement savings plan. The down side is a fee structure that could easily be double that of a conventional mutual fund portfolio.

SunWise Elite Plus is based on a menu of 47 different segregated funds, which are like mutual funds with capital guarantees. Seg funds are more expensive than conventional funds, which explains why the funds in the SunWise Elite Plus series have management expense ratios ranging from 2 per cent to as much as 4.09 per cent.

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Ted Rechtshaffen, president of TriDelta Financial Partners, recently analyzed SunWise Elite Plus and said a moderate growth portfolio could have an MER of up to 3.5 per cent. Add another 0.5 points for the guaranteed minimum withdrawal benefit and you've got a fee structure where the portfolio has to make 4 per cent before the investor sees any gains.

Mr. Rechtshaffen said the chances of losing money in the market diminish over the long term, and he noted that people are enjoying increasingly long lifespans. For this reason, he believes that guaranteed-minimum-withdrawal products are only worth the fees if you have a highly pessimistic outlook for the stock market.

"The guarantee only has value if markets are terrible over a long term, worse than they've ever been," he said. "If you really believe that will be the case, buy a GIC."

3. These investments have miscellaneous other costs.

For some examples of these costs, let's look at CIBC Total Premium Yield Deposit Notes, a series of principal-protected notes that are on sale until July 19. If you buy them, $3 of every $100 you invest goes to your investment adviser and reduces your invested amount to $97.

If you need to sell your notes in the first year, you must pay an early trading charge of as much as 4.25 per cent. The capital guarantee only applies if you hold to maturity, so you could end with a loss on your investment.

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As with all principal-protected investments, the CIBC notes also involve a potential opportunity cost. If you buy these three-year notes and end up with nothing, you've lost out on a chance to do better in other investments. Five-year GIC rates are in the 5-per-cent range at some alternative banks and credit unions right now. Buy one and you'll have a return you can bank on.

Making nothing is actually the same as losing money, by the way. If inflation were to average 2.2 per cent over the next three years, it would reduce the purchasing power of a $1,000 investment to $935.

Capital-protected investments are an unstoppable force right now in the financial marketplace, so there's obviously a hunger for ways to get into the stock market without the risk of losing money. Once you know the costs and limitations of this kind of investing, though, you have to ask yourself if risk-free exposure to stocks is worth having.

Protect Yourself

Capital-protected investments offer the opportunity to get exposure to the stock markets without the risk of losing money. While popular today, these investments have fees and conditions built into them that cut into their attractiveness. Here's a checklist of 10 things to look out for if you're considering a principal-protected note, an index-linked GIC or segregated funds with a guaranteed-minimum-withdrawal benefit:

Are there any purchase commissions or deferred sales charges if I want to sell before maturity?

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Does the capital guarantee apply if I sell before maturity?

Is there a market that will even allow me to sell before maturity?

What are the ongoing fees associated with owning this product, and what services or features do they cover?

What are the ongoing service fees that are paid to my adviser?

Are there any limitations on how high my returns can be?

What are the underlying investments (mutual funds, segregated funds, baskets of stocks, stock indexes etc.)?

How have the underlying investments performed in the past, and how often have they lost money?

What financial institution stands behind the guarantee?

How are my profits taxed at maturity or if I redeem early?

rcarrick@globeandmail.com

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