I’ve spent 20+ years in the investments business and I believe many investors often don’t understand what they’re buying.
I don’t think investment companies are purposely misleading people. Most employees at financial institutions themselves don’t fully understand the products and services they promote. They’re basically following instructions and repeat key messages provided to them by head office.
There are, however, some very astute executives who know full well the implications of what they’re doing, yet allow this to carry on.
They get away with it because the fine print is boring. Frankly, I doubt many people will get through this article without yawning a few times. That’s the trouble. The industry relies on investor disinterest in the details.
Many financial institutions profit from overcomplicating what they do and being less than transparent with product details. I’ve decided to start exposing these tactics in a new “Buyer Beware” series.
Part 1 is about market-linked GICs (known as market-linked CDs in America).
What are market-linked GICs?
Market-linked GICs are term deposits that provide a return that is calculated based on the performance of an underlying index. The general sales pitch for market-linked GICs is the investor participates in market appreciation while protected from downside.
These products are offered by financial institutions and count as liabilities on their balance sheets. In other words, someone buying a market-linked GIC is effectively lending the financial institutional money in exchange for a promised return. This is where the “guaranteed” part of GIC comes in. (Moreover, many are eligible for CDIC insurance coverage.) Similarly, plain vanilla GICs are financial institution liabilities, except they pay a pre-determined rate of interest and are not linked to a market.
Market-linked GICs are often promoted in the same space as vanilla GICs.
Do investors really understand market-linked GICs?
An investor looking to take advantage of 5%+ GIC rates might come across a web page with various GIC offerings. For example, a web page from a nameless bank displays a 2yr 5% GIC and a market-linked GIC. The market-linked GIC (linked to the S&P/TSX 60) offers a minimum of 14% up to 50% over 5 years. Based on what’s displayed on this page, many would think the market-linked GIC offers the more competitive deal.
While there’s nothing factually inaccurate about the information on this page, most investors don’t have the knowledge to make an appropriate evaluation.
First of all, the 14-50% return offered by the market-linked GIC is cumulative, whereas the posted rates for the plain vanilla GICs are annualized. An inexperienced investor would not know this. While there are footnotes informing readers of this, 1) how many people read the footnotes, and 2) how many people know the difference between cumulative and annualized returns?
To make a fair comparison, both rates/returns need to be shown on an annualized basis. (This is not as simple as taking the 5 year cumulative return and dividing by 5 because this wouldn’t account for compounding.)
After making the adjustment, the annualized return for the above market-linked GIC is minimum 2.7% and maximum 8.4%. These numbers are much less appealing when compared to a known 5% rate.
It’s important to note that 8.4% – the maximum return for this market-linked GIC – is lower than the average historical annual return for most equity indices. Also, it is extremely rare for equity markets to have a negative 5 year return.
Over the past decade, the S&P/TSX 60 total return was 9.17% annualized. You’re probably thinking “I can use this market-linked GIC to get a guarantee while only lagging the market by 77bps, assuming average market returns”. Not true. Even if the market returns 9, 10, 11% the market-linked GIC is likely to return much less.
The returns calculations for many market-linked GICs are tied to the price returns of the underlying index. This means dividends – a significant portion of total returns – are excluded from the calculation, resulting in a lower reference return for the product.
The difference between price and total returns is significant. For example the 10yr total return for the S&P/TSX 60 is 9.17% whereas the price return is 5.84%. To receive the market-linked GIC’s maximum annualized return of 8.4% the market would need to perform significantly above its long term norm. This means it is unlikely an investor will receive the maximum return.
The following illustrates the gap between total returns and price returns:
Again, all the information presented by the nameless bank is factual. But many of the details are buried in the disclosure documents, which nobody reads, while the easily accessible information is easily misinterpreted. Even if someone reads the disclosure documents in full, would they really understand? To be honest, I recognize this is a confusing article and I’m trying to be as transparent as possible.
What about the actual returns of market-linked GICs issued in the past?
So far everything I’ve explained is hypothetical. Market-linked GICs have been around for a while – what does the actual experience look like?
I found a 3 year market-linked GIC that matured on Nov 22, 2022. It’s return was 3.85% annualized. In contrast, the 3yr total return for the S&P/TSX 60 (ending Nov 30th, 2022) was 10.21% annualized.
Low returns – much lower than the linked index – are not unusual. Buyer beware.
Making matters worse, the returns from a market-linked GIC are likely taxed as income (because it’s technically an unsecured liability) rather than more favourable dividends and capital gains taxation for equities. So the after-tax experience is likely even worse than what I’ve indicated above.
Is there a place for market-linked GICs in a portfolio? I guess it could be an alternative to cash, but in this environment I think plain vanilla GIC rates and money market yields provide a compelling parking spot.
If you are ever pitched one of these products, here’s what you need to ask:
- What is the ANNUALIZED minimum and maximum return for the market-linked GIC and how does that compare to plain vanilla GICs and the average historical return for the market? Consider the differences in tax treatment.
- Is the returns calculation for the underlying market based on total or price returns? How much does the market actually have to rise to receive the maximum return? Is that realistic?
- Request a list of ANNUALIZED returns for recently matured market-linked GICs. This will give you a better sense of the actual investment experience. Be sure to get a good sample size.