A while ago I discussed how to build your own market-linked GIC. A friend (who prefers to remain anonymous) mentioned that his market-linked GIC has a maximum return. It turns out that he has what Scotiabank calls its “Market Powered” GIC or MPGIC.
This MPGIC is similar to other market-linked GICs in that its return is linked to a stock index. In this case, it is linked to the TSX 60 index of large Canadian companies. This GIC also returns only a fraction of the index return, called the participation rate or participation factor (PF).
Three differences with the MPGIC compared to other products I’ve looked at are
1. it guarantees a minimum return,
2. it caps the maximum return, and
3. it bases market return on the average index value over the whole time period instead of just an average over the last year of the GIC.
For the 3-year MPGIC, this page shows that currently the guaranteed minimum return is 0.5%/year and the maximum additional market-linked return is 20%. For some reason, this page does not mention the PF, and the detailed explanation on pages 60-64 of this document does not mention the maximum return. As a matter of fact, this document contains an example where the investor gets more than a 20% market return!
Once again, we’ll try to approximate the MPGIC with stock options. Let’s say that we have $100,000 to invest. The minimum return of 0.5%/year means that we are guaranteed to have at least $101,508 after 3 years. The best rate I could find on a 3-year regular GIC is 3.55%. If we invest $91,422 at this rate (leaving $8578), it will return $101,508 after 3 years. This takes care of the minimum guarantee for our self-constructed MPGIC.
The remaining $8578 can be used for stock options to get market exposure. As in the previous post, we can buy call options on the XIU exchange-traded fund (ETF). To simulate the maximum return, we can sell call options at a higher strike price.
To see how this works, imagine a stock trading at $10. We buy call 100 call options struck at $10, and sell 100 call options struck at $12. If the final stock price is under $10, all options expire worthless. If the final stock price is $11, we exercise our $10 options and sell the stock for a $1 per share profit, and the $12 options expire worthless. If the final stock price is $13, we exercise our $10 options, but the resulting stock gets bought from us for $12 per share by the holder of the $12 options. Thus, our return is capped at $2 per share (less commissions).
So, to match the MPGIC we’d like to buy call options struck at XIU’s current market price, and sell call options at a higher price that results in capping the return at $20,000 (20% of our original principal). Unfortunately, options on XIU only come at a few different strike prices. Also, the longest range options available expire in about 26 months instead of 3 years.
Friday’s closing price on XIU was $13.12, and call options in our range of interest had the following bid-ask spreads on the Montreal Exchange:
$12 strike: $3.20 to $3.69
$14 strike: $2.25 to $2.73
$16 strike: $1.27 to $1.97
$17 strike: $0.97 to $1.66
Let’s try buying $12 call options and selling $16 call options. If we get unfavourable prices on each sale we are buying at $3.69 and selling at $1.27 (a difference of $2.42). At these prices, our $8578 can buy (and sell) 35 option contracts (each contract is 100 options) with $108 left over that will more than cover commissions.
Multiplying the 3500 options by XIU’s current market price of $13.12 gives close to $46,000 for a participation factor (PF) of 46%. This is rather low. On the plus side, we actually make money even if the market stays flat because we bought call options at only $12. Our maximum market return is only $14,000, which is less than the $20,000 target.
If we repeat these calculations assuming that we can buy and sell options for prices in the middle of the bid-ask spread, the results are different. The PF would be 62%, and the maximum market-linked return would be $18,800.
This time, let’s try buying $14 options and selling $17 options. This will increase the PF, but we’ll only get a market return if XIU rises to at least $14. If we get unfavourable option prices, the PF is 63%, and the maximum market return is $14,400. If we get option prices in the middle of the bid-ask spreads, the PF is 96%, and the maximum market return is $21,900.
As we can see from these examples, whether we can do better that Scotiabank’s MPGIC depends on the participation factor they offer and the option prices we are able to get. It also depends on how you value the differences like the inexact option strike prices and the difference in relevant market return: MPGIC bases it on the average over the 3 years, and our self-constructed investment has its market return based on the value of XIU at the end of about 26 months.
I should reiterate that I’m not a fan of index-linked GICs for my own investments because I find the cost of the capital guarantee too high. I’d rather go for higher returns at the risk of capital loss.