“Eating clean” is the practice of sticking with unprocessed foods. Anything that comes in a package covered with artwork is shunned because it probably contains unhealthy additives, fillers and preservatives.
Often these extra ingredients serve only to make the food look prettier, last longer during transport, or reduce the cost of manufacturing. Ready-made products cost more, too, because you’re not just paying for the food: you’re paying for the packaging as well. All of which fattens the bottom line of the producers without giving you much nutrition.
Financial products are not much different. The more attractive a product looks, the more likely you are to buy it. But the cost of making financial products attractive can come at the expense of performance. Because these products are often complex, many investors have no idea what they are actually buying.
When leveraged ETFs first hit the market, some investors jumped at the chance to juice their returns. They seemed to promise double (and in some cases triple) the market return. If the underlying index goes up 5%, investors expect to earn 10%. You can even buy “inverse” versions that go up when the market goes down, and vice-versa. Investors who piled into these funds without understanding how they work were surprised to find that any holding period over one day meant all bets were off. Over longer periods it’s possible for both regular and inverse leveraged ETFs to lose value even if the underlying index goes up. Unless you fully understand how these products work, avoid them.
Complex financial products aren’t designed just to entice aggressive investors. Graeme Okurley, a MoneySense reader, has been looking into market-linked GICs. Rather than paying a fixed interest rate, these offer you a range of returns: if the stock market performs well you get some of that upside, and even if the market goes down your principal is guaranteed. “I’m pretty risk-averse when it comes to investing, so I figured these would be a good solution,” Okurley says. “The potential 0% return after five years doesn’t bother me much, as long as I am not losing what I put in. The problem is, these market-linked GICs seem too good to be true. Is there any catch I’m not seeing?”
Yes, there’s a catch. Market-linked GICs place limits on your upside: for example, your return may be capped at 60% of the actual return of the market. (Specific formulas vary from provider to provider and can be difficult to understand.) So if the market’s cumulative return was 30% over five years—that’s 5.4% annually—your share would be 18%. If the markets go up a more modest 20% (3.7% annually), your share would be 12%. Of course, if they are down over the five years, your total return would be zero. Meanwhile, a regular five-year GIC paying 2.5% a year gives you a cumulative return of 13.14% no matter what.
Let’s put that into perspective. If you put $100,000 into this particular market-linked GIC and the market was flat or negative, you would have given up a guaranteed $13,140. Even if the markets were up modestly, you would still have been better off with the plain vanilla GIC. That’s the catch: while it’s true that market-linked GICs protect your principal and offer some potential upside, you’ll likely come out ahead only when equity markets perform extremely well. As well, capital gains in the linkers are taxed as interest. These products sound appealing but if you are looking for low risk, you have to expect low returns.
“Investing clean” means avoiding complex products and sticking to the basics: individual stocks and bonds, plain vanilla GICs, and low-cost funds that don’t use leverage or other exotic strategies that promise more than they can deliver. If you can’t explain an investment in a sentence or two, that’s a red flag. Complexity in an investment product is almost always designed to benefit the company manufacturing it. All that fancy packaging is better for someone’s bottom line, but chances are it’s not yours.