Market-Linked GICs: Pros And Cons

Last update on April 11, 2015.

End of the world 

Think the end of the world is nigh? Market-linked GICs might be a great option for you.

 

Last week, I wrote a blog post on how market-linked GICs worked. In the post, I explained that you could replicate a market-linked GIC from home, by buying government bonds and call options.

Since then, I've gotten some - ahem - negative feedback from other financial bloggers who felt I was being irresponsible for telling you how you to replicate it.

While we all agreed that you could replicate market-linked GICs such that at worst, you generate a 0% rate of return (i.e. you neither gain nor lose money), the bloggers felt this was still 'risky'. I don't think most people would find a 0% rate of return (at worst) 'risky'.

That said, there really is no free lunch. Sometimes, you'll feel glad that you bought market-linked GICs, and other times, you won't. It all depends on how the market behaves.

In this article, I'll go through the pros and cons of owning a market linked GIC. I'll do this by taking the example of two hypothetical portfolios.

In the one case, let's assume that you invested 80% of the money in a TSX index fund, and 20% of they money in 2 year bonds yielding 1.2%/year. Let's call this the 80/20 portfolio.

In the other case, let's assume that you replicated a market-linked GIC such that you were guaranteed 90% of the investment. Let's set the term at 2 years.

Now, let's see how they do under various market scenarios after 2 years.

Pros: When Market-Linked GICs Shine

Scenario 1: Let's say that the stock market had 2 fantastic years. Over the 2 years, the TSX went up by 50%. In this case, our 80/20 portfolio would have gained roughly 40.5%. Stocks would have contributed about 40%, and bonds about 0.5%.

Our market-linked GIC replica on the other hand, would have returned about 54% over the two years. So it did even better than the pretty aggressive 80/20 portfolio. Not bad for a portfolio that can only lose 10%!

Scenario 2: Let's say that the stock market had a terrible 2 years. Over the 2 years, the TSX went down by 50%. In this case, our 80/20 portfolio would have lost 39.5%. Stocks would have lost you 40%, while bonds would have lessened your pain by only 0.5%.

Our market-linked GIC replica though, would have preserved 90% of its value, (i.e. losing only 10%). In this sense, this portfolio is substantially 'safer' than the 80/20 portfolio.

Cons: When Market-Linked GICs Suck

Scenario 3: Let's say that stock market had a flat 2 years. After all is said and done, the TSX settled at exactly the same place it started at 2 years ago (i.e. it returned 0% over 2 years).

In this case, the 80/20 portfolio would have returned 0.5% over the two years. Stocks would have returned nothing, while bonds returned 0.5%.

What about the market-linked GIC replia? It would have lost you 10%.

Why? Because the call option that you bought would have expired without any value.

For example, let's say that you bought a call option on XIU.TO. That means you bought the right to buy XIU.TO at $18 at any point between now and two years from now.

If XIU.TO settles back down to $18 two years from now, then the option is worthless. Your option entitles you to buy XIU.TO at the same price that you can already buy it from the market otherwise.

Why I Don't Generally Recommend Market-Linked GICs

Let me summarize what the scenarios are telling us.

Market-linked GICs are great under extreme circumstances, but poor under more normal or mediocre circumstances.

If you buy market-linked GICs, then in a way, you're betting on an uncertain future. It means you either see an apocalypse, or a gold rush. Nothing inbetween.

Some savvy readers might say, "Aha! In that case, I'll buy/replicate market-linked GICs in times like 2008, when the future does seem very uncertain."

Not so fast.

Because guess what? During those times, market-linked GICs become much more expensive to implement, because call options become more expensive. That means the future had better be very uncertain indeed for the strategy to pay off. Even medium level movements in stock prices won't guarantee that market-linked GICs will be worth your while.

At the end of the day, of the 3 scenarios stated above, scenario #3 (or something similar) happens much more often than the other two scenarios. Therefore, I generally don't recommend buying or replicating market-linked GICs.

Exceptions

That said, there may be times when someone might still want to buy or replicate market-linked GICs.

Some people may have a very high risk tolerance, but at the same time might need to preserve a certain amount of money. Maybe you've ear-marked some money to buy a boat, and don't mind losing the rest of the money. I don't know.

But also, and more importantly in my mind, some of you might just be curious. Maybe you'll want to actually try out replicating market-linked GICs with a small amount of money, and see how it turns out.

Ever since I began learning how to invest, I experimented. If I hadn't, I don't think I would have become the investor I am today.

Before I actually started investing, I read different books on investing. But it all seemed Greek to me. Sure, I knew what a P/E ratio was in my head. But I didn't know how that applied practically until I actually started investing.

If you're serious about learning, I invite you to experiment too, with small amounts of money. I still experiment today as well - that's how I translate theoretical knowledge into practical knowledge.

Playing with call options might indeed seem like playing with a saw - You might get your fingers cut now and then, but if you don't experiment a little, you won't be able to make a beautiful piece of furniture.

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