Whipped but not beaten

Kelly Rodgers, MoneySense September 2002

IN THESE TURBULENT TIMES, most of us are on the lookout for a safe place to put our savings -- investment that makes money whether markets are up or down. Not long ago, some financial advisers talked as if they had found this perfect investment when they began to push "structured products."

Structured products hold U.S. and Canadian stocks just like a plain-Jane equity mutual fund. But while mutual funds are content to sit and wait for their investments to rise in value, structured products toss in a kicker -- these funds attempt to generate extra income by writing call options on their holdings. These options give other investors the right to buy the fund's shares at a certain time and for a certain price. The idea is that if the stock market drifts sideways or bounces around, the structured product will still make money from writing call options on the shares it owns. If the market goes up, things are supposed to get even sweeter -- you make money from the options and you also benefit from rising stock prices.

All of this sounds great in theory, but it hasn't worked out in practice. When structured products were being touted last year, money managers promised yields that exceeded 10%. When managers failed to deliver on their promises and slashed yields earlier this year, investors turned on structured products with a vengeance.

I think much of this bad publicity is an overreaction. True, structured products were never perfect investments and, yes, the hype was sickening at times. Structured products shine when the market is volatile and edging upward. They don't do well if the market is falling.

However, the basic strategy of writing call options to generate cash is sound. Indeed, structured products are a good bet for investors who understand what they are and how they work. They may be suited to your portfolio if you need to generate income outside your RRSP and you can stomach the volatility that arises when stock markets fall.

As always, you have to shop carefully to get a good deal. Remember that simpler and cheaper is to be preferred. You should expect to pay annual management fees of at least 1.25%, but the lower this fee, the better the long-term performance is likely to be. Don't be lured into paying more for useless bells and whistles.

The most popular enhancement is a capital guarantee, which means that you are assured that your original investment will be returned to you after a certain number of years (usually 10 or 12) even if the fund has lost money. I wouldn't bother with this guarantee, because funds that offer it must devote part of their assets to buying the necessary insurance. They're left with a smaller asset base to generate their returns. Consequently, these funds will tend to generate lower returns -- or the manager must take on more risk in pursuit of those higher returns.

You have to keep your expectations reasonable. With funds that offer a capital guarantee, 40% of the original capital is typically used to buy forward contracts that will protect the funds' capital. The remaining 60% is used to buy stocks against which options are written. This means that the targeted yields have to be generated with only 60% of the capital. That can be a pretty tall order when the targeted yield exceeds 8%. I would expect annual yields of no more than 3% to 6% on funds with guarantees and 5% to 8% on funds without capital guarantees.

Most of the structured products that do not have a capital guarantee trade as closed-end funds on the Toronto Stock Exchange. Others are available directly from managers as either pooled funds or open-ended mutual funds.

'The fund I like best also happens to be the oldest. Mulvihill Capital Management launched the Premium Canadian Fund (TSX: FPI.UN), a mix of Canadian bluechip stocks, six years ago. The performance of the fund from June 1996 to July 31, 2002 has been good, with an annualized return of 9.6%. The total return of the Toronto Stock Exchange over the same period has been only 5.3%. The fund has an annual targeted distribution of $2 a unit and the units were trading in the $20 range in late August. If you're on the lookout for income, this fund is a good place to start.