Market-Linked GICs: Have your stock cake and eat it too

Interest rates are low, yet people still tuck money away in money market funds. In the U.S., where stock markets are near record highs, more than US$2.5 trillion, almost 20% of all funds, is still parked in money market funds. It earns safe, meagre returns that are only slightly better than putting money under a mattress.

But where should one invest? Choose bonds and you run the risk you may lock in to low rates just as they move higher. You could lose value as bond markets adjust. As for stock markets, an old friend used to say trees don’t grow to the sky. At some point they stop. Stock markets could even go down from here. Investing is a dilemma.

What if you could preserve capital and still participate if stock markets rise? The recent RRSP season saw a slew of advertisements that touted ‘Market-Linked Guaranteed Investment Certificates’ with various names that played on the theme of ‘smart.’

These are GICs that offer the security of a traditional GIC one can get at a bank. The difference is payments are based primarily on the performance of stocks. The best part is the incremental return accrues only if markets rise rather than fall. Sounds too good to be true, like ‘having your cake and eating it too,’ doesn’t it?

This type of product has been around a while, but seems to have gained popularity recently. Investors kick themselves after missing out on the returns in the stock markets, especially last year. However, the global financial crisis that crushed many portfolios has resulted in a more cautious approach by many, if not most.

The biggest bank in the country, RBC, offers several ‘MarketSmart’ GICs. Principal is guaranteed, so at a minimum you get your money back at maturity. There is also, sometimes, a minimum guaranteed return. Typically it’s not much, but better than nothing. And you have the opportunity to get a higher rate of return, based on how various stock markets do.

What’s the catch? If there’s an upside to markets, there may be a cap on the return passed on to investors. If stocks scream higher, you’re limited to a maximum, which is a function of the GIC’s maturity and the index it’s tracking. For example the RBC US MarketSmart GIC tracks the S&P500 index, capping out at 5% if you invest for two years. In the interim, you’re guaranteed a minimum 0.5%. If willing to commit for a longer time, five years, the maximum is 25% and minimum 5.25% (as of March 25th). For contextual purposes, in 2008 the S&P was down 38%, but was up 30% in 2013. From early 2008 to the end of 2013, the index was up 25.8%.

Most financial institutions offer variations on this model. Sometimes there’s a guaranteed minimum return, sometimes not. Usually there’s a set maximum return, on the order of 2% to 3% per year, but some products offer unlimited upside returns. Those are set as a percentage of the return of the underlying index. For example, if an index is up 5% you may receive only two thirds of that, or 3.3%. If up 30%, you get 20!

Too good to be true? Some think so. According to InvestRight, a program of the B.C. Securities Commission, these products are protected by the same entity that protects any bank deposit, CDIC. They are a no-fee alternative, which everybody likes.

But selling them easily before they mature is problematic. Typically you get back only your principal.

Perhaps the biggest issue most people have with these products is that returns are unknown and not particularly flexible. That makes them hard to incorporate into financial plans. Markets fluctuate, so you’re at the mercy of the maturity date and flexibility is sacrificed. But isn’t that the whole point? Slightly higher risk with potentially better returns and knowing you can never lose principal. Besides, if investors were any good at market timing, they wouldn’t be looking at this product anyway!

My personal bias is that many of these products track indexes with which I’m already comfortable. Why would I want to earn interest based on an index that tracks a bank or utility index when I could just buy an ETF that tracks the same index? The ETF spins off dividends, often more than 4%, and is taxed favourably. By contrast, the GIC return is highly taxed as interest income. The GIC return is based on index numbers you may read in the papers, and which don’t include dividends as part of the return.

On the other hand, these type of GICs provide relatively low-risk access to broad U.S. or global markets to which many investors want exposure. They’re not bonds, but they do fulfill the fixed-income component for asset allocation.

To sum up, market-linked GICs* are moderately complicated and lack some transparency and flexibility. But they give me the comfort of knowing I can’t lose money. At the same time, I am, and to a maximum, invested in the stock market.

As Marie Antoinette once said “Let them eat cake.”

Pat Bolland is a veteran financial broadcaster currently with Sun News Network. His Twitterfeed is @patbolland.

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