Blessed by the Potato

There have been a few questions in the fora recently about market-linked GICs. From the description, they sound like the best of both worlds: sharing in the returns of the stock markets with full, government-backed downside protection. I’m sure that’s where a lot of the attention is coming from. Unfortunately the reality is far different: these are usually sneaky products (only including partial performance, caps, etc) so it usually ends up being the case that if you need downside protection you’re probably better off to just get a regular GIC (where you’re guaranteed some return too) and a regular low-cost market index fund for the bit of exposure you can tolerate.

I just saw a new version of this trick in a product from Meridian credit union that promised “No cap on returns, no fees, participate in 100% of return.” The sneak on this one comes in the way they calculate the return:

The interest earned will be based on the average return of the index for the five years of the investment period. The average is calculated by adding the month-end closing values of the index and dividing the sum by the total number of months.

So if the index is at say 100 now and closes at 134 after 5 years (a total 34% return or 6% compounded annually), you’d only get ~20% return (or about 3.7% compounded). That hardly sounds like participating in 100% of the return to me, and that’s not even getting into the matter of how these products conveniently forget the dividend yield, or that the return you get is counted as interest income rather than capital gains (like it would be if you had invested in the markets).

It also makes the return path-dependent: if the market goes down for the next 4 years, then rallies hard in the last year to finish up, you’ll get far less out of a product like this than if you had just invested in the market. For example, if the market goes down 10% and stays down that much for 4 years, then rallies in the final year to finish at 134 (the same ending value as the previous example), you’d get nothing.

Though to be fair, this method would still give you some return if the market tanked just before redemption. But a regular GIC would likely give you just as much or more in that scenario, and you’d at least have a predictable return, too.

So how do you go about making your own version of these types of products? Well, one way is like I said above, buy a GIC and an index fund. If you figure that the worst 5-year return you need to protect yourself from is -25% (and even then you’d have to be really unlucky — but you can get more pessimistic if you wish), then just figure out how much you can risk for a given regular GIC rate so that even in that “worst-case” scenario your principal is still protected. Right now a regular 5-year GIC can be had for 2.75%, which would give a total return of ~14.5% after 5 years. If the amount to put in a GIC is g and the amount to put in the markets m and your total principal p, then you have two equations with two unknowns: the amount to invest at first g + m = p and the amount you have left at the end in your worst-case scenario: (remaining stock value)*m + (GIC total return)*g = p. Using my example numbers (predicting that even in a bad stock market outcome 75% of the value would remain after 5 years, and that the GIC would return 14.5%) that second equation becomes: 0.75m + 1.145g = p. Pull out some grade school arithmetic, and you find that you if you have $1000, you can risk investing $367 in the market while putting $633 in a GIC, and still be very likely to have at least $1000 at the end of your 5 years.

If the market performs well, at say that 6%/year I used above when examining the Meridian GIC, you’d walk away with $125 in profit from the equity investment, and $92 from the GIC, for a total return of 21.7% over the 5 years. Plus, you’d collect any dividends paid out by the companies in the index giving you a fairly significant boost to returns, get a slightly more tax-efficient mix of income, and you wouldn’t care how you got to the end point at the end of the 5 years. If the market doesn’t perform well, things can get a touch complicated: if the market ends up returning 3%/year, you’d get less than that from the market-linked GIC scheme, but nearly 3% from this plan (since the vanilla GIC-portion is also yielding about 3%). If the market goes down, the tax situation can be a little more complicated because instead of ending up with nothing, you end up with taxable interest income from the GIC plus a capital loss from the mutual fund.

The big issue is that though in all likelihood this scheme would give you every bit as much principal protection as a market-linked GIC, based on historical 5-year returns, it’s not actually a guarantee. If a new stock market crash hits that’s off the charts (like the 30’s — an investor in 1929 had a 5-year return of -75%), then this approach will fail. I don’t think it’s really worth worrying about events that are even worse than the 2008/2009 credit-crisis crash (which is where I got my worst-case 5-year -25% from — and even then, your timing had to be unlucky to the month to be down that much).

To get an actual guarantee with a scheme like this you can instead invest more in a GIC and use options to get that bit of market exposure. Preet and Michael James described that some time ago. The issue there is that you may notice they say things like “for a $100,000 investment…” because the options route just isn’t feasible for someone with a smaller amount of money to invest (like ~$1000 for a market-linked GIC).

In the end, removing risk or providing a guarantee ends up being costly almost no matter how you construct it (though the DIY-option allows you to collect more of the upside from the market). With a lot of ways to get less than the interest from a regular 5-year GIC, these market-linked products are usually a bad deal if you do need absolute protection.