Can a product deliver both safety and high yields?

Posted by on August 3, 2010 in Investment Products

The holy grail of investment products for many investors would be something that delivers both protection of principal and delivers high yields/returns (I would define high yield as over 5-6%. The demand for these types of products always exist but tend to increase greatly during time of market uncertainty. The issue is that, while some of these products work as advertised, many fall short of the expectations.

But, banking on the short-term memories of the investing public, the investment industry resorts to financial innovation to replace one generation of failed product – good bye principal protected note- with another generation- hello “factored structured settlements” or funds promising both capital preservation and high yields.

Regardless of the name or marketing quirk, there are always a few things to remember about products which attempt to protect principal while promising yield/return.

You can’t have your cake and eat it too. To quote Larry MacDonald on the same topic: “A fundamental principle of investing is that there is generally a trade-off between risk and return. If you want safety of principal, you have to accept a lower yield; if you seek a higher yield, you need to take on more risk.” This is not to say that one cannot invest in a product that aims to protect principal and provide high yield/return but…

You get what you pay for in life. Principal protection products  are generally achieved in one of four ways: (i) insurance (the principal protected note method); (ii) active management through constant re-balancing of a portfolio or purchasing of derivative instruments (options, shorts etc.); (iii) relatively heavy costs involved in setting up a structured product; or (iv) a combination of all three. In other words, there’s a cost to protecting the principal side not to mention the usual costs of delivering high yields/returns; in hindsight, it is possible to have your cake and eat it too but it will be one expensive cake.

Liquidity is a concern. Logic dictates that a manager of these products would have a hard time delivering on principal protection and even modest returns if investors are selling the products constantly. The need to maintain cash to meet redemption requests may either result in: (i) not enough money left to purchase instruments to protect principal; or (ii) leaving little to invest in yield/return. The manager’s simplest solution then is to prevent, or severely limit, redemption of the product. You can’t fault the manager for this but it should alert an investor not to buy any products if they require cash in the short to medium term.

These types of products are neither good or bad in the abstract. They are created to fill a need but there’s a cost to everything in life. As usual, investors need to be aware whether there is a sufficient trade-off between potential benefits and those costs.

For the DIY crowd, Preet previously outlined how to create you own principal protected note. Please feel free to share if you have other principal protection strategies.

Good luck.

5 Comments on Can a product deliver both safety and high yields?

By larry macdonald on August 3, 2010 at 8:41 am

Real return bonds can protect principal in real terms.

By Preet Banerjee on August 3, 2010 at 9:52 am

Thanks for the link Thick – hope you enjoyed your time off! Unless you were just super busy with work, in which case: you need some time off! :)

By admin on August 3, 2010 at 7:44 pm

Preet- a little from column A and a little from column B.

Larry- real return bonds don’t tend to track inflation perfectly. Its a good tool but not a perfect one.

By Financial Ramblings on August 6, 2010 at 6:14 am

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By This and That: Investing according to Dilbert and more… | MoneySense on August 6, 2010 at 10:22 am

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