The large amount of macro uncertainty plaguing the world today has led to a boom in financial products that hope to alleviate one’s concerns and hedge risk.Hedge funds, of course, have always promised to hedge risk and offer absolute returns but they have not delivered for a ten year period compared to traditional portfolios.Gold is also consistently touted as a hedge for catastrophe but it appears to have lost some of its lustre this year.The other major products that I have seen flogged lately are Principal Protected Notes (“PPN”). Don’t be fooled.There are no free lunches out there.Where there are guarantees you are likely paying for them in unexpected ways. What follows are some things to consider when looking at PPNs.PPNs are investments that produce returns while providing protection to the investor.They are debt-like instruments with a set maturity date on which the issuer agrees to repay investors the amount originally invested (the principal), in addition to a return that is tied to the performance of an underlying set of assets (such as a portfolio of stocks, a market index or a portfolio of funds). PPNs generally only guarantee the return of nominal principal.Although an investor’s principal is guaranteed there are numerous other risks and costs that investors need to consider when investing in PPNs.Risk with PPNs1. Liquidity Risk: PPNs generally have no open liquidity outside of that provided by the note sponsor. The secondary market provided by the sponsor often comes with penalties for early redemption and there is often no guarantee of having your full principal reimbursed early. In fact there is often a severe penalty applied for an early redemption.Most PPNs lock investors up for 5 to 10 years which essentially eliminates access to these funds without penalty.2. Performance Risk: Often times the performance of a PPN does not resemble the performance of the underlying assets it has been created to track.This is usually due to higher fees and costs that the notes charge. Since many equity-linked PPNs I have seen match returns to capital appreciation only and not total return, this can be a significant risk.From various studies I have seen, reinvested dividends can amount to nearly ⅔rds of the total long term return for stocks. Leaving this out of an investor’s potential return seems to me to be a big mistake.3. Inflation Risk: A PPN guarantees the return of principal but does not take into consideration the impact of inflation on the capital invested.4. Credit Risk: The PPN is in essence an unsecured deposit with the sponsor who issues it; therefore, an investor should always check the credit rating of the PPN issuer.Weakening credit ratings may hinder the sponsor’s ability to maintain liquidity as its ability to trade in derivatives markets may become compromised.5. Currency Risk: Some PPNs deal in assets outside of the investor’s base currency.Declines in foreign currency may have a negative impact on the overall return on the investment if this aspect is not explicitly hedged.Costs of PPNsThere are a number of costs that investors need to consider when assessing the value of a PPN.These are split into explicit costs (those specifically disclosed) and implicit costs (those costs not immediately visible).Explicit Costs include:1. Commissions: These include up front charges (sometimes as high as 5%). Most of the time they are levied when one does not buy the product directly from the sponsor.2. Management Fees: PPNs often have management fees for actively managing the underlying asset or constructing the portfolio.Often times these fees are higher than the simple index funds or ETFs which they are trying to replicate returns for.3. Early Redemption Fees: As discussed above, liquidity is restricted on most PPNs and early redemption of an investment can come with a steep penalty. Many PPNs offer a deferred sales charge that declines over time.Implicit Costs include:1. Performance Averaging Formulas: Many PPNs final payouts are not structured to generate the underlying return of the basket of assets or indices they are created to match. This is because the returns are often subject to averaging formulas which are typically based on monthly returns. This may raise or lower the total return received by investors.2. Performance Participation Cap: PPNs with performance caps promise to pay returns earned on the underlying assets only up to a maximum amount. If returns exceed this cap, investors actually forgo the extra return and bear an opportunity cost.3. Interest on Leverage: Some PPNs use leverage to enhance returns. Although this cost is often not excessive it is still implicitly born by investors in the product.Is a PPN Suitable for You?It’s always best to consult your financial advisor before considering the purchase of any product.In general, however, there are a number of aspects to consider if a PPN is suitable for you.First of all, PPNs are generally not suitable for investors who require regular and more predictable income to fund their lifestyle.Some PPNs may have distributions but most specifically exclude interim payments and final receipt is not made until expiry.Also, investors who require liquidity should not purchase PPNs. As stated above, although the sponsor may offer a secondary market, the fees and penalties associated with early withdrawal may be extremely prohibitive.PPNs do make sense for some investors who are extremely risk-averse.They may have the ability to take risk but do not have the willingness to do so.In this case, after reviewing all aspects of the PPN, it may be appropriate to provide this investor with exposure to certain asset classes without the risk of investing in them directly.Also, for investors with long term horizons and established sources of liquidity, PPNs could be used as a cash substitute. Since returns on certificates of deposits (CD) and T-bills are microscopic and offer no real rate of return today, PPNs can enhance cash returns by providing the potential for a higher yield on a portion of the cash portfolio while protecting the principal. It’s important that the investor has sufficient emergency funds available as this “cash portion” would need to be considered a restricted part.In general, for investors who have a longer term time horizon, a properly diversified portfolio of stocks and bonds should be able to outperform a PPN while keeping risk to an acceptable level. PPNs generally offer lower returns than the assets they track over longer periods because of their operating costs and expense ratios.This is the price one pays to alleviate fear.Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.