Analyst: Simple structure of JPMorgan's Russell 2000 ETF-linked accelerated note could pay off

By Kenneth Lim

Boston, Sept. 17 - An accelerated growth product linked to the Russell 2000 index shows that simpler is often better, a structured products analyst said.

JPMorgan Chase & Co. plans to price a series of zero-coupon buffered return enhanced notes due April 13, 2012 linked to the iShares Russell 2000 index fund.

If the underlying ends above its initial value at maturity, investors will receive par plus double the gain, subject to a maximum total return of 18% to 24%. Investors will receive par if the underlying finishes flat or declines by no more than 15%. Investors will lose 1% of their principal for every 1% decline in the underlying beyond 15%.

The exact return cap will be set at pricing.

"This investment product offers potential enhanced returns on small to moderate market gains," Future Value Consultants said in a research report. "However the principal is at risk."

The product can be viewed as a one-for-one index tracker with a few twists: giving up dividends, having downside protection and ramping up the upside to a cap, said Future Value Consultants managing director Tim Mortimer.

"In return, you maximize your chance of a very solid return," he said.

Investors who are "lower-risk equity investors" will probably be most attracted to the notes, rather than fixed-income investors, Mortimer said.

"There's not really enough yield prospects in there to kind of call it fixed income," he said.

High overall rating

The product has a high overall score of 8.35 out of a best possible 10 on Future Value Consultants' system, while enjoying a relatively low "riskmap" score of 3.21 out of a riskiest possible 10.

The overall rating, in turn, got a boost from a high value rating of 9.76 out of 10, which reflects the firm's estimate of the product's value after accounting for costs from direct fees and profit margins related to the underlying derivative.

"We deem the value of the underlying assets is pretty high as a function of the payoff and the structure and the associated risks," said Mortimer.

Some of the factors that the firm takes into account are the volatility skew and dividend yield of the underlying as well as the current interest rates, Mortimer added.

It helps that the product is linked to a commonly used index fund, which suggests that investors can easily find similar products from rival banks. This puts pressure on issuers to price the product more aggressively.

"These products are very competitive products to begin with," Mortimer said. "The individual-stock products, the timing is everything, and it's a little bit harder to prepare stuff."

He noted that products in the United Kingdom that are linked to the FTSE also tend to have the best fee structures in that market.

"When you stray away from the FTSE, or you get a more complex risk/reward profile, fees get higher," Mortimer said.

Simplicity matters

The notes also illustrate the value of simple structures, Mortimer added.

Accelerated growth products tend to earn higher overall ratings and less risky scores from Future Value Consultants, he noted. He drew a comparison against reverse convertibles, which are typically linked to single stocks and mature in much shorter durations but are riskier and more costly for the investor.

"Accelerated products that you typically see in the U.S. are quite a different species from reverse convertibles," Mortimer said. "The accelerated one is usually one to 1.5 years, linked to an equity index, perhaps with a buffer in there as well. The reverse convertible is often three to six months, linked to stocks with the intention of generating a higher yield because the stock is more volatile. Even if the stock has good prospects, there's still volatility in there."

Even then, figuring out what a structured product is really worth can be complicated. Mortimer believes that looking at the probabilities of getting different ranges of returns helps an investor to better understand the risk/reward profile of a product, which is why Future Value Consultants features a probability table prominently in its reports.

For this product, the estimated probability of getting par or better at maturity is 76.7%, and the estimated probability of suffering a loss is 23.3%.

"At the end of the day it's a question of, is it a proposition that works for you?" Mortimer said. "The forward-looking test is what we prefer to focus on."

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