JPMorgan's four-year 0% notes linked to ETF Efficiente 5 index target conservative investors

By Emma Trincal

New York, Feb. 8 - JPMorgan Chase & Co.'s upcoming 0% notes due Feb. 20, 2015 linked to the JPMorgan ETF Efficiente 5 index are designed for conservative investors and are based on a recently created index being used for the first time in a note, a source said.

The index, which is rebalanced monthly, tracks the excess return of a portfolio of 12 exchange-traded funds above the return of a cash constituent, the JPMorgan Cash Index USD 3 Month, according to an FWP filing with the Securities and Exchange Commission.

The ETF Efficiente index selects the portfolio with the strongest performance that has an annualized realized volatility equal to or less than 5%. To do that, the index methodology ranks the 12 ETFs by performance first and then selects the optimal allocation based on the volatility rule.

First use

"The index, created in November, is used for the first time in this note," a source said.

It provides exposure to a range of asset classes and regions based on the selection of ETFs that perform the best with the least volatility, he said.

JPMorgan created in November two other versions of the same index - the Efficiente 8 and the Efficiente 12 - targeting volatility levels of 8% and 12%, respectively.

The payout at maturity for the notes will be par plus at least 100% of any index gain and will not be less than par. The exact participation rate will be set at pricing.

Safe play

"It's a balanced, diversified portfolio that should really appeal to the most conservative investors," the source added. "It's either for investors approaching a life cycle like retirement or others who fear the market and are sitting on cash and money markets. Advisers may use the product as a bridge to bring those people back to equity and help them diversify."

Along with the cash constituent, which can represent up to 50% of the portfolio, the following 12 funds make up the basket: SPDR S&P 500 ETF trust, iShares Russell 2000 index fund, iShares MSCI EAFE index fund, iShares Barclays 20+ Year Treasury Bond fund, iShares iBOXX Investment Grade Corporate Bond fund, iShares iBOXX High Yield Corporate Bond fund, iShares MSCI Emerging Markets index fund, iShares Emerging Markets Bond fund, iShares Dow Jones Real Estate index fund, iShares S&P GSCI Commodity-Indexed trust, SPDR Gold trust and iShares Barclays TIPS Bond fund.

The index gives investors exposure to the following five sectors: developed market equities, bonds (including Treasuries and corporate bonds), emerging markets, alternative investments (broad commodities exposure, gold and real estate) and inflation.

Each allocation is subject to individual asset and sector caps.

Autopilot

"If you want to incorporate a momentum-based strategy while minimizing volatility, it can be a very good play," a market participant said.

"You're protected on the downside, and you're uncapped on the upside.

"It's going to automatically adjust on a monthly basis and allocate to asset classes that are performing the best. You're on autopilot. For a retail investor, it's kind of a nice way to have a disciplined approach."

"The concept is interesting," said Frederick Wright, partner and chief investment officer at Smith & Howard Wealth Management. "It forces you to automatically rebalance monthly based on the volatility."

Bulls and bears

But Wright said that the index strategy may not be as attractive in bull markets given its low volatility.

The back-tested performance of the index since July 1999 included in the prospectus showed that the strategy outperformed the S&P 500 Excess Return index during down market periods or over long periods of time.

For instance, the annualized return for the three years prior to October 2010 was 5.14% for the Efficiente index and negative 8.66% for the S&P 500 Excess Return index.

On the other hand, when stock prices rose, the index underperformed the benchmark. In the last 12 months, the S&P 500 index is up 16% while the Efficiente index gained 9.26%.

Wright said that the index appeared "to lag in a bull market," which would be a concern.

"I'd have to see how this index works in a bull market," he said.

"The index is not going to do as well during a bullish momentum simply because of the asset allocation caps and the asset caps. It's not going to allow you to chase returns in a sector that has momentum. The volatility rule limits your performance," the source said.

On the other hand, the index can smooth returns over a long period of time because it "avoids peaks and troughs," he noted.

Lower option cost

A product based on low volatility also offers pricing advantages, the market participant said, which in turn can translate into better terms for investors.

"With interest rates so low, options cost you more," the market participant said. "You can either offer a low participation, you can put all sorts of caps, or you can create an index that has a very low volatility."

"The lower the volatility, the cheaper the option will be, all things being equal," the source said.

Noting that the JPMorgan ETF Efficiente 5 index was the less volatile of the three in the series, the source said that the investor ultimately benefited with this product in terms of reduced duration.

"With the Efficiente 5, you can have a four-year principal-protected note, while you would have a six-and-a-half-year [note] with the Efficiente 8," the source said.

He said that when investors have the choice between the three different indexes, their preference may boil down to short versus long maturities rather than low versus high volatility.

Complexity

Some financial advisers object to proprietary indexes that emanate from issuing banks.

"I generally prefer standardized, well-known popular indexes because my clients understand them," said Wright.

Explaining the product was also a concern.

Wright said that explaining the notes to investors would be time-consuming, from going over the 12 different ETFs to explaining the index methodology itself.

"My clients don't like complexity. In general, the simpler the index, the more attractive the note is," he said.

But the market participant said that for financial advisers who are already using ETFs for their clients, the strategy may be appealing.

"I like the product for registered investment advisers. If you're already doing ETFs, all it does is [allocate] between ETFs using a smart strategy," he said.

"A lot of investors are very familiar with ETFs and may find this product attractive. But there's clearly a lot of education work that needs to be done," the source said.

The notes (Cusip: 48125XBY1) are expected to price Feb. 17 and settle Feb. 23.

J.P. Morgan Securities LLC is the agent.

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