A Guaranteed Zero

01/02/2012 10:15 am EST


John Heinzl

Reporter and Columnist, GlobeInvestor.com

Canadian investors would have done better by buying a conventional guaranteed investment certificate than BMO's "market-linked" product, writes John Heinzl, reporter and columnist for Globe Investor.

A year ago I wrote about a product called the BMO Blue Chip GIC, which Bank of Montreal pitched as a way to achieve potentially higher returns than a traditional GIC "with the same safety net attached."

I wasn't impressed with the complex and lopsided formula the bank used to calculate the product's return, however, and called the GIC "a great deal for the bank, but a lousy deal for you."

Now that the results are in, let's see how this "market-linked" GIC actually performed to determine whether it lived up to its billing as a safe alternative in a stormy market. BMO issues a new Blue Chip GIC every month; we're focusing on the "Series 1" GIC that was issued on December 8, 2010, and which matured on December 8, 2011.

The Formula
First, let's briefly recap how the product works.

Over its one-year term, the GIC offered a guaranteed minimum return of 0.2%. Depending on how a "reference portfolio" of stocks performed from December 8, 2010, to the "calculation date" of November 24, 2011, investors could earn up to an additional four percentage points of "variable return," for a maximum potential return of 4.2%.

In an environment of rock-bottom interest rates, that seemed pretty tempting.

The reference portfolio consisted of ten Canadian stocks:

  • Power Corp of Canada (Toronto: POW)
  • Goldcorp (Toronto: G)
  • SNC-Lavalin Group (Toronto: SNC)
  • Thomson Reuters (Toronto: TRI)
  • Fortis (Toronto: FTS)
  • Toronto-Dominion Bank (Toronto: TD)
  • Rogers Communications (Toronto: RCI.B)
  • Brookfield Properties (Toronto: BPO)
  • TransCanada (Toronto: TRP)
  • Canadian Natural Resources (Toronto: CNQ)

It's important to note, however, that the investor didn't actually own the stocks or receive the dividends. Rather, the price change of each stock was plugged into the formula to determine the GIC's variable return.

Specifically, if a stock rose—no matter how much—it was deemed to have an "effective return" of 4%. If a stock fell, the effective return was the same as the actual price change, with losses on each stock capped at negative 10%.

The variable return was then calculated as the average of the effective returns. This amount was then added to the 0.2% guaranteed return to determine the GIC's final return. If the average effective return was negative, the variable return was deemed to be zero.

The Results
I won't go into all the gory details, but suffice it to say that 2011 was a lousy year for the market, and seven of the ten stocks fell. As a result, the variable return on the GIC was zero.

So, in exchange for locking up their money for a year, BMO Blue Chip GIC investors earned the minimum return of 0.2%. Worse, after inflation of about 2.9%, they lost about 2.7% in real terms. They would have done better by buying a conventional GIC that was paying about 1.75% at the time—more if they locked in for a longer period.

A Better Way
Products like the Blue Chip GIC appeal to investors who want higher returns without extra risk, but it doesn't work that way. To get higher returns, you have to accept volatility.

What's more, you have to be prepared to invest for longer than a year, because stock returns are far too unpredictable in the short run. A common rule of thumb is that, if you're putting money into the market, you should not need the cash for at least five years.

Bottom line: If you can't afford to lose principal, invest in a traditional GIC (or high-quality bonds). If you're seeking the higher returns of stocks, invest in equities directly, or through a mutual fund or exchange traded fund that gives you ownership of the companies and pays you dividends, which are an important component of the market's total return.

The best option is to build a balanced portfolio of stocks and GICs or bonds that suits your investing goals, risk tolerance and time horizon. That way you won't be tempted by products that serve the financial institution's interest, and not yours.

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