I prefer not to name the particular product Colin is considering, so I’ve edited his question somewhat:
I am looking at a term deposit product. In the description they state ‘Market Participation: 100% or higher depending on the issue.’ Can you describe what they might mean by Market Participation in this context and, in addition, how it could be greater than 100%?The product Colin is considering is linked to the S&P/TSX 60, which is an index of 60 of the biggest companies in Canada. It guarantees a minimum of 4% interest after 5 years (about 0.79% per year), and may pay more based on a calculation related to the S&P/TSX 60 stock index.
The advertising claims a “Market Participation” rate of “100% or higher.” This sure sounds like you get all the stock returns if stocks go up (or maybe even more than all), but none of the losses if stocks go down. But Colin is right to be suspicious. There are three unpleasant surprises hidden in the detailed calculations.
The first bit of bad news is that the interest upside is capped at 27% over 5 years (4.9% per year). The advertising actually says that the range of annual returns is from 0.8% to 5.4%, but in the real world we have compound interest.
The second piece of bad news is that the S&P/TSX index doesn’t include dividends paid by the companies that make up the index. Dividends are an important part of stock returns that stock owners receive. But investors in this product will not benefit from dividends.
And finally, the returns are roughly chopped in half by an averaging calculation. Instead of just calculating stock returns by looking at prices at the beginning and end of the 5-year period, they take the prices each month for 60 months and average them all. The “return” is then based on the starting stock prices and this average figure. Typically, this will cut returns by slightly more than half. Then this “Average Growth” figure is multiplied by the market “Participation Rate.”
So, the advertised 100% market participation actually consists of removing dividends, chopping the remaining return roughly in half, and then capping it if it still happens to be too high. This is definitely a case where reality doesn’t live up to the marketing.
Why not just go with plain vanilla products? I can appreciate there is an abundance of financial marketing for many products but I'm not sure these products are helping Canadians - as you point out.
ReplyDeleteAnother example, preferred shares. I struggle with these investments. You have bond-like exposure to rates and your upside when compared to common stocks is marginalized.
Simple is better I think. Good post Michael.
@Mark: Thanks. What appeals to people about these products is their design to make it seem like investors get upside and no downside. It's yet another case of reality not matching marketing.
DeleteThanks for your article Michael, those are three great points, the 5 year 27% cap, lack of dividends, and the averaging system.
ReplyDeleteGreat article, Michael. I just hope some of the folks who are being sold these read your post and heed your advice. We're up against a big machine...
ReplyDelete@Steve: Glad you liked it. I'd be very happy to have a larger audience.
DeleteGood reminder Michael- thanks. The SEC put out a paper on structured notes that others may find helpful as well: http://www.sec.gov/oiea/investor-alerts-bulletins/ib_structurednotes.html#.VNjxQfnF98G
ReplyDelete@Chris: Thanks for providing this link. The SEC note is solid information, but I think it has to be interpreted for the vast majority of people. If you ask the typical investor in a market-linked GIC whether they own a structured note, they'd answer 'no.' If you made them read this SEC information on structured notes and ask the same question again, most would likely answer 'I don't think so.' Like any field, financial jargon baffles non-specialists.
DeleteI'm amazed people still go for these products! You're a more diplomatic man than I, I would have identified product and called them out on it.
ReplyDelete@John: I was worried that I might actually help to promote the product if I mentioned it. Sadly, just about every bank and bank-like entity in Canada seems to have similar such products.
Deleteha ha - good point! Yeah, they're pretty easy money for the financial institutions, so I guess it would be expecting a lot for them to refrain from offering them.
DeleteUnfortunately my credit union, Alterna, sells these. I pretended to not understand them at the branch in order to hear the explanation and was disappointed that they weren't well explained, and the downside was omitted. The information on their website isn't any better. I expect this from a bank, but from a credit union?
ReplyDelete@Anonymous: I suppose that some people who understand the pros and cons of such an investment might still choose to buy one. But few people understand them. The most disappointing part is that these products are designed to make people think they are much better than they are.
DeleteYup, great money making product for the bank and heavily promoted. Complexity in the explanation reels in the loyal bank customers because they love their bank advisor and believe that they're acting in their best interest. When I told the nice ladies at CIBC that I would never leave my money in a bank, and that I only visit a bank when I'm trying to obtain more money and expand my credit, they looked at me like I had 3 heads.
ReplyDeleteNEVER buy what the bank is selling!
@Peter Wolf: My experience with bank employees is limited, but I've never got the sense that they know much about how to handle money. They just do what they're told by their employers.
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