Principal Protection Likely Isn't Worth the Costs
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 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.
- 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.
- 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.
More on Moneywatch:
Book Review: John Bogle's Don't Count on It
A Motley Fool and His Money Are Soon Parted
Will Bill Miller's Stock Picks Make You Rich?
Why Keeping Your Investments Local Is a Bad Strategy
Quest for Alpha: 10 Rules for Being a Successful Investor
Three ways I can help you become a wiser investor:
- Follow me on Twitter: http://twitter.com/larryswedroe.
- Read my latest book The Quest for Alpha.
- Listen to my radio show every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. You can also download the podcast of the show via Buckingham Asset Management's iTunes page.