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A Primer on (Market) Equity linked GICs





As seen in an earlier post, traditional GICs offer security of principal with a low rate of return (in the current interest environment) for locking in the money for set time periods. The longer the term, the better the rate offered. Callable GICs provide a better rate than traditional GICs to compensate for the risk that the issuer retains an option to call the GIC after a set time period. Another type of GIC that is available is the equity-linked GIC, which we will discuss in detail below.

The Return

As the name suggests, an equity-linked GIC offers an investment return based upon the performance of a major equity index such as S&P/TSX 60 Index, S&P 500, or a weighted basket of international stock market indices. Such a GIC offers principal protection, while providing the opportunity for potentially higher returns than a traditional GIC. However, the return of an equity-linked GIC is variable as it depends on the performance of the underlying stock market index.

Equity-linked vs. Traditional GICs

As with other investment vehicles, the risk versus reward profile is applicable to equity-linked GICs also. These GICs seem to offer the best of both worlds – security of the investment and potential for higher returns. Nonetheless, in the event of the underlying equity index performing poorly, the GIC may not pay any interest upon maturity. So, the investor would receive his principal “as is”, while inflation may have eroded the purchasing power of that amount. Depending on the amount invested and term of the GIC, the erosion may be significant.

Let us consider an example to understand the impact better. Investor A has $1000 in an S&P 500-linked GIC for a term of 3 years, while Investor B has $25,000 in the same GIC for the same term of 3 years. Unfortunately, due to global crises, all equity markets, including the S&P 500 Index, perform poorly over the next 3 years. Both investors will receive their principal amounts back ($1000 for A and $25,000 for B) without any interest paid at maturity. What are their initial investment amounts worth after 3 years (i.e., upon maturity), if the annual rate of inflation remained constant at 2.5%? Investor A is left with $928.60 and Investor B has $23,214.99 in real dollars after accounting for inflation.

The above examples may portray equity-linked GICs in poor light, while making traditional GICs seem better. Traditional GICs offer a guaranteed rate of interest, albeit low, to aid in mitigating the impact of inflation. However, there is no chance to partake in stock market gains, if they happen. The bottom line is that both GICs face the threat of losing purchasing power to inflation. It is the responsibility of every investor to weigh the opportunity cost and decide if they prefer the low but guaranteed interest rate of the traditional GIC or the potential for higher returns offered by the equity-linked GIC, while running the risk of receiving no interest at the end of the term.

Typically, money invested in equity-linked GICs cannot be accessed until maturity. This is in contrast to most traditional GICs, where the funds can be withdrawn by paying a penalty in the form of a reduced interest rate or no interest receivable (for very short terms).

Editors Note – Market Linked GIC Downsides

  • Market returns are based on a participation rate.  Basically, this means that if the market does gain over the term, you will only be paid a portion of those gains.
  • From what I can gather, market returns on these products do NOT include dividends, which can be a large portion of market returns.

Canada Deposit Insurance Corporation (CDIC)

CDIC insures investments ranging from $1 to $100,000. Investments could be in savings/chequing accounts, GICs, and other term deposits with a date to maturity of 5 years or less. So, equity-linked GICs with terms less than 5 years are eligible to be insured by the CDIC. However, please be aware that investments including GICs held at credit unions are not backed by the CDIC but insured by respective provincial bodies.

Are equity-linked GICs suitable for a portfolio?

As with any stock market investment vehicle (e.g. individual stocks, mutual funds, or ETFs), an investor with a long investment time horizon (several years) can consider holding an equity-linked GIC in their portfolio. Conversely, if an investor is using GICs as a short-term parking spot for money to be used as the down payment on a house, for a car, new furniture, etc., then it would be prudent to use traditional GICs or a savings account. As always, read the features and benefits section of the investment vehicle before committing your money.

Do you hold equity-linked GICs? What is your investment time frame? Did your decision to buy such GICs turn out to be fruitful?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.  You can read his other articles here.





15 Comments, Comment or Ping

  1. 1. Wendy

    Are there any exchanged traded equity linked GIC that we can buy via self-directed portfolio?

  2. 2. Ed Rempel

    Hi Clark,

    It should be added that equity-linked GICs only give you a portion of the return of the stock market. The formula’s typically include a “participation rate” and an “average value of the last year”, and often have a “maximum return”.

    For example, I looked up the formula for the RBC Canadian Market-linked GIC. It used a participation rate of 60% and the average closing value of the last 12 months.

    To illustrate, let’s say you buy a 3-year GIC and the market makes a straight-line 10%/year. The GIC would take an average of the last year, so it would only pick up half the gain of year 3. Then it would add the 10% from years 1 and 2, to get a total gain of 25%. Then it would multiply that 25% by the “participation factor” of 60% to net at 15%.

    In short, in this simple example, the index rose 30% and the index-linked GIC rose 15%.

    This particular GIC at RBC does not have a maximum.

    In short, index-linked GICs are a way to avoid the downside and get SOME of any growth, typically about half of the growth of the index.

    Ed

  3. 3. Anthony

    I’m pretty disappointed with this post, as it left out many disadvantages of equity-linked GIC’s. There are a couple of big ones that immediately come to mind…

    Taxes: In an unregistered account, any gains are taxable as income, not capital gains.

    Caps and how returns are calculated: Some market-linked GICs have a cap on returns, while others have a participation factor, so limiting your downside risk comes at a cost. Some banks also use some funny math to calculate the return, such as taking the average index value of the last 12 months. All the complicated math is designed to further stack the odds in the banks favor.

    Lack of dividends: Equity performance is determined by the combination of capital gains (loss) plus dividends. The return on market-linked GIC’s is calculated solely by the change in the raw index, ignoring dividends (which is always positive). The banks know this too… that’s why they offer higher caps and participation factors on GIC’s linked to low-growth/high-dividend sectors like financials and utilities… because they’re unlikely to hit those caps.

    In my opinion, market-linked GIC’s are designed to exploit naive investors who are looking for a higher return without added risk.

  4. 4. Fit

    One option is to create your own linked GIC. I personally would use an interest accumulation annuity because of the beneficiary, creditor protection, etc. (same rates as GIC just not sold by banks haha) but I digress. If you had $10,000 to invest, and could get 5% on that over 1 year (I wish!) Invest $9523.81 @ 5% and take the $476.19 and invest it in something yourself…. doesn’t matter what. At the end of the term, you will have $10,000 for sure and hopefully you did well with the $476 haha

  5. 5. CommanderT

    Well, you could invest the 476.19 in a call option on whatever index you want your return linked to. If you bought an option that is “at the money” then this combination would have an identical return to one of these market linked GICs (with the exception that the participation factor would almost certainly be different based upon the number of options that could be purchased with the 476.19).

  6. 6. Ed Rempel

    Hi Anthony,

    I agree with your assessment. Personally, I would not buy one.

    Guarantees are always expensive. You have to understand the cost of any guarantee.

    A far better option to get the gain of the stock market with a principal guarantee would be seg funds. You can get 100% of the growth including dividends and have it taxed as capital gains, plus you can get a principal guarantee after 10 years.

    Seg funds are a much better choice than index-linked GICs.

    However, seg funds also come with a higher cost, say .5-1% higher than the same investment without the guarantee.

    If you look at how rarely the stock market is down after 10 years, you realize the cost is probably not worth it, except for some clients for emotional reasons.

    Here are the stats. The worst 10-year period ever for the S&P500 was a loss of 1.47%/year. This was 1999-2008. The second worst was a loss of 1.40%/year from 1929-38. In total, there have been four 10-year periods that have been negative, out of 132 10-year periods on record.

    In short, historically, there has been only a 3.0% chance of a loss over 10 years and all of them were small. Paying .5-1%/year to protect against this is not worth it, except possibly for purely emotional reasons.

    My opinion – if you want to make an equity return, then you need to be willing to accept the volatility. If you want guarantees, make sure you always understand the full cost. Guarantees are almost always extremely expensive.

    Ed

  7. 7. Fit

    no risk no reward…. plain and simple. If you want to be in the market then… be in the market. If you don’t understand the basic correlation of more reward requires more risk then you shouldn’t even be anywhere near market based investments. The 1% “fear premium” IMO on a seg fund is easy money for an insurance company for exactly the reasons Ed mentioned. For most people concerned about the “guarantees” the are actually more concerned about cash flow… they just don’t know it. A conservative market approach has the same amount of risk as a GIC, the risks are just different…

  8. 8. Clark

    @Ed: Appreciate the better insight and details about the method of calculation.

    @Anthony: Agree that the points you have raised are important that I should have at least touched upon them. Thanks for the thoughts!

  9. 9. Fit

    I think that what people need to realize is that there is no free lunch… it is as simple as that. As soon as people understand the concept of opportunity cost… the picture gets a little clearer

  10. Thanks for sharing this great post! You know how much my savings account is payin in interst? .1%. Pathetic.

  11. 11. DJ

    I just had a market linked GIC cashed in friday….. 20% return for 3 years..i think timing was important since i got it right after the markets crashed..but it returned more than my stocks did in the last 3 years with 0 risk and a 2.5%/yr minimum return.

  12. Does anyone have a good link to “typical” terms for these equity-linked GICs? Also, how short a period can you get them for? As the period shortens it seems even more “heads I win, tails you lose” from the investor’s perspective – I can’t see how any entity could write such a contract without charging an options-like premium.

  13. 13. Geoff

    I agree with Anthony – not mentioning that dividends are NOT paid by market-linked GICs when that can be a sizeable amount of the return each year is irresponsible. Suggest updating the main post for those who don’t read the comments.

  14. @DJ, if you were invested in the market by itself, you would have returned 60%+ not including dividends over the three year period.

    I will make a couple additions to the article.

  15. 15. SST

    @FT: “invested in the market by itself” HOW exactly?

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