You can always tell when the stock-market seas start to get choppy. Brokers and financial institutions talk up safety and stability, touting investment vehicles that emphasize minimizing risk and guarantees.
Here's one: the principal-protected note. These notes appear to offer investors the best of both worlds: a guaranteed return of principal combined with the chance to participate in the gains of hot markets. Yet a close look at these structured investments shows that they're far from a no-lose proposition.
Upside without downside?
The gimmick behind principal-protected notes is similar to what you'll see with equity-indexed annuities. You agree to invest your money in the notes for a certain period of time, usually between two and seven years. The return on the notes is typically tied to the return on a certain index. If the index rises between the time you invest and the note's maturity, then you earn a percentage of the return. If the index falls, however, you don't lose anything -- but you get your original investment back.
You can find principal-protected notes that are tied to all sorts of asset classes. For instance, JPMorgan Chase (NYSE: JPM ) currently offers a note that's tied to the returns of the Japanese and European stock markets. Lehman Brothers (NYSE: LEH ) offers foreign currency-based notes; one covers Latin American countries, and another includes China and India. UBS (NYSE: UBS ) has a note that's tied to an index of commodities. These particular notes have participation percentages that range from 100% to 275%.
Paying the opportunity cost
But I have a few concerns with these notes. First, they often don't perform well. One product from CIBC, for example, gave investors exposure to a portfolio of stocks that included Boeing (NYSE: BA ) , Johnson & Johnson (NYSE: JNJ ) , and 3M (NYSE: MMM ) . Yet after nearly five years, the note has an average return of less than 5% per year. And that's during a period when the S&P 500 is up about 12.5% annually.
And even though equity-indexed annuities have their own problems, they at least give investors some exposure to the broad stock market -- a prudent investment that makes sense for the long term. Principal-protected notes, on the other hand, seem to focus on hot, speculative markets that have performed extremely well in the recent past. For most investors, buying something with returns based on how the Chilean peso performs isn't much different from making a bet at the track. The proliferation of currency notes preys on investors' fears that the dollar may not recover.
More importantly, however, the guarantee offered by principal-protected notes isn't as valuable as it sounds. In exchange for tying up your money for several years, all you're promised is a zero return. Yet even with the safest of investments, you can find FDIC-insured CDs that pay 5% on your money, which would turn $1,000 into $1,400 over seven years. So potentially, you're risking $400 in lost interest. If you'd have invested that in the stock market with its 10% average return, that opportunity cost rises to nearly $950.
Principal-protected notes claim to be a no-lose investment. But investing your hard-earned money in these notes means that instead of having a smart long-term investment, you're gambling that a hot market will stay hot. That performance-chasing often doesn't turn out well.
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