Principal Protection Likely Isn't Worth the Costs

Last Updated Mar 11, 2011 12:06 PM EST

My Buckingham Asset Management colleague Kevin Grogan, who also co-authored The Only Guide You'll Ever Need for the Right Financial Plan with me, was recently asked to analyze a principal-protected CD pitched to one of our clients by their bank. We are asked to evaluate dozens of these structured products each year. Before we even analyze them we know the following is virtually certain:
  • The complexity will be designed in favor of the issuer.
  • Retail investors will be attracted by some type of guaranteed downside protection.
  • The cost of the protection will be excessive, though it's likely the buyer won't be able to figure that out.
  • No institutional buyer would touch it, due to the excessive cost of the protection.
  • There will be a more efficient way to accomplish the same objective.
The actual CD was slightly more complicated than the hypothetical example below, but the example we'll discuss here is quite similar.
  • The CD is a debt instrument, and the principal is FDIC insured. The CD is linked to the Dow Jones UBS Commodity Index.
  • The least the investor could receive is their principal back at the end of five years.
  • The investor receives the return of the Dow Jones UBS each year, capped at 10 percent and with a floor of -20 percent. The investor receives the sum of the five years of returns, without compounding.
The main attraction of the investment is the guaranteed return of principal. The problem, as is often the case, is that you give up too much upside to obtain the downside protection:
  • You do not receive any of the return of the commodity index above 10 percent. Commodities are a very volatile asset class, so this cap is very important when evaluating the investment.
  • There's no secondary market for the investment.
To demonstrate how important this cap is, let's consider an alternative portfolio that was 50 percent commodity index and 50 percent rolling short-term CDs, rebalanced annually. The data covers 1992 through 2010, and we looked at rolling five-year periods.
  • The average total return for the portfolio was 36.0 percent. The average total return for the CD was 17.0 percent. In fact, the maximum return for the CD is a total return of 50.0 percent, and that could only occur if commodities went up at least 10% in each of the five years you owned the CD.
  • There wasn't a single five-year period (out of 15 periods) when the CD would've outperformed the simple portfolio.
  • There was only one period (again, out of 15) where the commodity index had negative returns for a five-year period, and the CD's principal protection would have protected the investor.
  • Of the 19 years examined, the CD's cap came into effect 11 times. The CD's floor came into effect twice.
Two things should be clear by now. First, you give up much more upside potential than you gain in downside protection. Second, these investments are incredibly complex, and you can be sure that the complexity isn't designed in your favor. To use March Madness metaphor, in a competition between the sophisticated institutions who design these products and the retail buyer, the institutions are a #1 seed and the buyer is a #16 seed.

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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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