Why You Should Avoid Equity-Linked GICs

Years ago, a clever banker must have come to a realization: many investors want equity-like returns but are not comfortable putting their capital at risk. In other words, they want the reward of the stock market but the presumed stability of a safe fixed income product.

And so, the equity-linked guaranteed investment certificate was born. Sometimes called market-linked GICs, these products would appear, as one commentator put it, to allow investors to have their cake and eat it too.

With an equity-linked GIC, your initial investment is fully guaranteed by the bank. What this means is that at the end of the term (typically three or five years), you will at least get your money back. This aspect of the product is designed to give people peace of mind. It appeals to those who are risk-averse and nervous about the stock market.

At the same time, equity-linked GICs offer the potential for significantly higher returns than traditional GICs. The way they do this is by tying the return to the performance of a specified market index. For example, an equity-linked GIC that is tied to financial stocks in Canada will do well if those equities rise during the product’s term.

The hybrid nature of these GICs is their selling point, and it’s one that banks in Canada heavily market. Take the Royal Bank, for example. Speaking of their Canadian Market-Linked GICs, their website says these “offer the best of both worlds – the security of a GIC and the growth potential of the equity markets.”

So, should investors buy equity-linked GICs?

There are reasons to be cautious. The devil is always in the details, as the saying goes, and it’s important to note that these products aren’t the free lunch everyone would love to have.

For one thing, depending on the particular GIC in question, an investor may end up making no money by the end of the term. Some banks will offer a minimum return, such as 1.00% over three years, but this is pretty negligible. Others simply say you’re only guaranteed to get your principal back.

There are two big downsides to only having your initial investment returned to you. For one thing, a dollar invested today is worth more than a dollar three years from now, due to the effects of inflation. Put another way, the real, inflation-adjusted return of an equity-linked GIC can actually be negative. Furthermore, by not making any money over a three- or five-year term, an investor suffers what’s called an opportunity cost; that is, the foregone benefit of having been invested in something else. Even a traditional GIC would have been a better bet if your equity-linked one yields nothing.

It’s easy to understand how an equity-linked GIC can end up backfiring on an investor: if the stock market, or at least the market sector to which the GIC is tied, stays flat or declines over the product’s term, an investor will make little or no return.

Second, equity-linked GICs (as the banks themselves fully admit) are not the same as equity investments in a few important respects. For one thing, an individual who buys one of these GICs is not entitled to dividend payments from the underlying companies in an index. Because dividends are a crucial source of equity returns over time, this omission is important.

In addition, banks usually (though not always) limit how much you can make by owning an equity-linked GIC. This is done in two ways. One way is to specify what’s known as a participation factor. For instance, if the participation factor is 60% (which means if a market index rises 10% over 3 years), the equity-linked GIC will return 6% over that same time frame. Another way banks cap the potential rewards is by setting a maximum return. With the TD Security Plus GIC, to use one example, investors’ gains are capped at 8.88% over the whole three-year period.

Finally, it’s worthwhile to keep in mind that equity-linked GICs are not particularly tax-efficient. Where capital gains from equities are treated favourably by the CRA, any return from an equity-linked GIC is considered to be interest income. Thus, the entirety of the return is taxed at an individual’s marginal tax rate.

The bottom line is that most investors, if they want equity-like returns, should have some sort of direct exposure. It should be long term in nature and part of a balanced portfolio. (I would note, however, that the stock market in my opinion is currently overvalued. Being overweight in equities is not something that strikes me as a good idea at the moment.)

Nevertheless, if you want the maximum possible gains associated with stocks, be they dividends or capital gains, you’ll get them from purchasing equities or index funds yourself, not via equity-linked GICs. They’re well-marketed and appeal simultaneously to our greed and our fear. Still, most investors are probably best taking a pass.

Andrew Hepburn is a freelance writer in Toronto, specializing in economic and financial issues. From 2006 to 2009 he was a Research Associate with Sprott Asset Management focusing on commodity markets. He is a Queen's University. graduate. ahepburn20@hotmail.com