Because I was one of those keeners that nobody ever likes, I was investing in stuff before I was old enough to even drive. For some reason, this did not impress the teenage ladies of Drumheller, Ab. Whatever, ladies. I was over you as soon as I found out you didn’t have pillow fights in your underwear during sleepovers.

My investing experience back then was mostly in GICs. I had no idea how the stock market worked and I wasn’t old enough to buy mutual funds. At least, that’s what I was told. Maybe nobody wanted to deal with me because I didn’t shower that often back then.

So I was happy getting my 4-5% on GICs because it was the late-1990s and banks actually paid interest. It was all fine and good — until the nice lady at the bank approached me about investing in a market-linked GIC.

The sales pitch was compelling. If I bought a market-linked GIC, I’d be guaranteed my principal while participating in any potential stock market upside. Thus, it was a no-lose proposition. I immediately signed up for a three-year market-linked GIC.

The year was 1998, and I was locked in until early in 2001. The stock market cooperated, and I made a little money. It was so long ago I can’t even remember how much, but I don’t remember being particularly impressed with the result.

Forget about me, this blog is all about you. Should you buy a market-linked GIC? Let’s have a boo.

What exactly are they?

Like I mentioned, market-linked GICs are marketed as a way for risk-adverse investors to get exposure to the BIG SCARY WORLD of the stock market with a minimal amount of risk. If the market goes up, you get to keep the gains. If it goes down, you don’t lose a thing.

Unfortunately, the products aren’t quite as they’re billed. I know. I’m more disappointed than the teenage girls of Drumheller, Ab.

The issue is there’s a cap to just how much you can make over the life of the investment. Let’s take a closer look at the first result I found when Googling, the market-linked GIC from CIBC.

CIBC offers market-linked GICs that cover all sorts of different markets, ranging from a biotech one to one that tracks its popular Monthly Income mutual fund. I picked one that tracks a global portfolio.

This product closes on December 3rd and will remain in force for three years (one of the reasons why I picked that one is because it only has a three year maturity, most others involved locking up your cash for five.) This GIC even pays a small guaranteed interest rate of 0.10%, but maxes out at a 4% annual return.

Plus, you’re not 100% protected. If the value of the index falls by up to 10%, the value of the GIC will go down in value as well. You’re capped at a 10% loss.

Yawn. That’s not a very exciting product. It doesn’t even offer a principal guarantee. Let me see if I can find one with that feature.

What a principal guaranteed market-linked GIC looks like

Royal Bank offers a very traditional market-linked GIC. It comes in a three-year term and it’s tied to the TSX 60 index. And, most importantly, it offers a 100% principal guarantee.

The Royal Bank market-linked GIC seems complicated, but it really isn’t so bad (there’s a formula and everything!). Essentially, you’ll share in 60% of the market’s potential upside based on the average of the last 12 months before maturity.

So using a really simple model, if the market stays flat for two years and then goes up 1% per month over the last year, you’d get 60% of 6%. That works out to a whole 3.6%, while money you would have put in the stock market would be up 12%.

No wonder banks love these things so much. Even if the market ends up lower, it would be easy for the bank to use a small percentage of the original investment to bet against the market using options. Either way, the bank is making money on these products.

Can you create your own market-linked GIC?

Okay, forget this noise. Let’s show you how you can very easily built your own market-linked GIC. We’ll use the TSX 60 ETF for this, XIU.

First thing you want to do is buy 100 shares of this ETF, which will cost you $2029 (plus commission) at the time of this writing. You can figure out how to do that, right?

Next, you’ll need to use a put option to guarantee your principal.

Here’s how put options work, at least for our purposes. If you buy a put, it gives you the right to sell 100 shares of the underlying stock at the price noted. So if our TSX 60 ETF falls to $18 in the meantime, we’ll have a product that guarantees us the right to get $21 for the shares we just bought.

You still follow? Okay good. Here’s a screenshot to help you out. Remember, Canadian options are traded on the Montreal Exchange. This is easily done via your online broker.

2018 $21 XIU Put

You’ll notice something. The last price paid for that option was $3.19. Which means it’ll cost you $319 to protect your investment for two and a half years. That’s a lot to pay for protection, frankly. This reflects the fact that, for the most part, puts are used to bet against something, not as insurance.

There’s an easier way. If you buy puts for only about a year out and round down instead of up, you can but much cheaper insurance. Observe.

Sept 16 XIU $20 Put

Let’s see some actual numbers, using the two examples above.

Assuming you buy: 100 shares of XIU ($2029) and the you buy the March 2018 puts for $21 ($319). And remember, we have to add in XIU’s 3% dividend each year for 2.5 years, which we’ll assume stays constant.

If the market goes up 10% Value of shares: $2231.90
Value of puts (worthless)
Value of dividends: $152.18

Total invested: $2348.00
Gain/Loss: 35.18 +1.5%

If the market goes up 10% per year

Value of shares: $2700.59
Value of puts (worthless)
Value of dividends: $152.18

Total invested: $2348.00
Gain/Loss: $504.18 or a gain of 21.5%

If the market loses 10%

Value of shares: $1826.10
Value of puts: $274
Value of dividends: $152.18

Total invested: $2348.00
Gain/Loss: -$95.72 or a loss of 4.8%

If the market loses 10% per year

Value of shares: $1479.14
Value of puts: $621
Value of dividends: $152.18

Total invested: $2348.00
Gain/Loss: -95.72 or a loss of 4.8%

As you can see, it’s not effective to buy the long-term puts to create your own market-linked GIC. How about if you use the shorter duration puts?

We’ll run just two scenarios this time, with the market returning 10% and the market declining 10%.

If the market gains 10%

Value of shares: $2231.90
Value of puts: (worthless)
Value of dividends: $60.87

Total invested: $2188.00
Total gain/loss: 4.75%

If the market loses 10%

Value of shares: $1826.10
Value of puts: $174
Value of dividends: $60.87

Total invested: $2188.00
Total gain/loss: -5.8%

As you can see, even this isn’t the best way to build your own market-linked GIC. The insurance is too expensive.

So how do the banks do it?

That’s a good question. If anyone knows, please let us all know in the comment section.

Here’s what I suspect. Since these aren’t terribly popular products, the bank puts the cash in whatever index it’s tracking and takes its chances. Most of the time, the bank is going to make money, and so they take their 40% off the top and everyone’s happy. And if the market declines, the small amount it has in these products barely registers on the bottom line.

Plus, they get to collect the dividends. Investing in the TSX 60 today would yield you about 9% over a three-year term in dividends. So if the market declines 5% over the three years, the bank is still up.

Does anyone have experience investing in market-linked GICs? Are there any bank employees out there that know how they create these products? Inquiring minds want to know. 

Tell everyone, yo!