Wells Fargo's protected notes tied to Vanguard ETF offer broad exposure with averaging payout

By Emma Trincal

New York, Aug. 9 - Wells Fargo & Co.'s 0% market-linked notes with upside participation and averaging due March 6, 2020 linked to the Vanguard Total Stock Market index fund are designed for investors seeking a conservative investment for broad exposure to the U.S. equity market, said Suzi Hampson, structured products analyst at Future Value Consultants.

But the averaging used to calculate the return is an important feature that should be carefully examined.

"This is a low-risk product for investors who want exposure to a broad U.S. equity market. But the final return is not based on the typical point-to-point but on averaging the returns every quarter during the period. This lesser-known feature has a significant impact on the return potential, one that investors need to really grasp," she said.

If the ending price is greater than the initial price, the payout at maturity will be par plus 100% to 110% of the gain, with the exact participation rate to be set at pricing. If the fund falls, investors will receive par, according to a 424B2 filing with the Securities and Exchange Commission.

The final price will be the average of the closing prices on the last trading day of each February, May, August and November from November 2013 through February 2020.

Averaging

The average ending price could be less than the fund's closing price at maturity, according to the prospectus. If so, investors in the notes would get a lower return than what they would have received if the payout had been calculated point to point.

"Averaging will reduce the price of the call used to increase the upside participation," she said.

"Issuers sometimes use averaging as a way to reduce the negative impact on performance arising from a last-minute fall in the underlying. But this one is capital-protected, so you don't need to get that type of protection. What you need is growth, and unfortunately, averaging is not helping growth. In fact, averaging returns over an entire period can actually dampen growth.

"Imagine a fund steadily growing say by 1% a year. Over a 10-year period, you get 10%. Now take the same performance but instead of looking at it point to point, you do the averaging of the 1% performance per annum. That gives you 5.5% instead of 10%. The averaging cuts your growth quite significantly. This is the bad part of it. The longer the period, the worse the impact. And the more points, the worse the effect as well.

"Quarterly calculation during six-and-a-half years is going to affect your growth. It had the potential to limit some of your losses, but you don't need that here. This is why the option was cheap for the issuer.

"Averaging is not something you would expect an investor to fully grasp by just reading the brochure. But it has significant consequences on your performance. It's not something that most investors are familiar with either. So it's important for them to understand the direct implications."

Future Value Consultants in its research assesses risk, return and price using a variety of proprietary scores in order to compare a product with others.

These notes belong to the principal-protected notes category, which comprises products offering participation of at least 100% on the upside and 100% of principal guaranteed for the downside, subject to credit risk, said Hampson.

Because interest rates are at historical lows, principal-protected products are not that common anymore, she said.

"This one is a six-and-a-half-[year] product. In this category of structure, we see much longer products," she said.

"The underlying is a little unusual. This is a fund that replicates a broad equity market, the U.S. market in its totality."

The fund tracks the MSCI U.S. Broad Market index, which represents 99.5% of the market capitalization of all U.S. stocks. It has a one-year implied volatility of 13, just slightly less than the S&P 500, she said.

Standard structure

"As far as the structure, this is quite standard. You get 100% capital protection, and with a participation rate of 100% to 110%, it's likely that you'll get slightly more than the index. We classify as principal-protected products those based on the call option. We do not include rates type of products, which have a much longer maturity, such as fixed-to-floaters," she said.

Hampson compared the payout to a direct investment in the fund.

"Having the participation slightly above 100, you should perform better than the fund. However, it may not be the case when you take into account dividends, which you don't get as a noteholder. But the small amount of gearing might make up for that," she said.

"If the final participation rate is set at 100, then obviously the dividends can make a difference in your return. But if it's at 110, you might outperform the fund even without the dividends.

"You have to look at it as a trade-off. You don't have the dividends, but you do have the 100% capital protection. Your dividends are paying for the protection. As the full protection reduces the risk, you would expect some reduction of the return by some measure."

Future Value Consultants compares each product with two different averages: same product type and all products recently issued.

The key metrics of risk, returns and price are measured through various scores established by Future Value Consultants. The research methodology generates reports designed to assess the quality of a product compared to the rest of the market.

Riskmap

The riskmap measures on a scale of zero to 10 the risk associated with a product with 10 as the highest level of risk possible. It is the sum of two risk components: market risk and credit risk.

The market riskmap of the notes is 0.72. It is higher than the average market riskmap for the same product type of 0.64.

The riskmap, which integrates credit risk, is 1.54 versus an average of 1.92 for the same product type.

"When we score risk, we're not just talking about losses. We're talking about how your performance would compare with a cash investment based on the risk-free rate. In this case, with a riskmap of 1.54, you would not be beating the cash performance. You would be finishing lower if the market ended up flat or lower," she said.

"This could be due to the quarterly averaging. If your investment is fluctuating around, you would end up getting less than cash."

The notes have a 0.82 credit riskmap. In comparison, the average for that structure category is 1.28.

"The credit risk is much lower than other similar structures," she said.

"It could be because this principal-protected note has a shorter maturity than most products in this category. So you would expect to have a lower credit risk.

"Also, Wells Fargo has relatively tight credit default swap spreads. The five-year CDS spreads are 66 basis points. In comparison, Bank of America is 114 [bps]."

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

"The return score is based off the bullish scenario in this particular case. With the uncapped upside and the long maturity, such market scenario gives you the potential for really high returns," she said.

The notes show an 8.47 return score, compared with an 8.24 average score for the same product type.

"The return score is higher than similar products but not by a great difference. The uncapped return probably helped for the slightly higher score," she said.

The average return score for the all-products category is 6.75.

"Comparing these types of products with all products is not really meaningful though. The reverse convertibles that you find in abundance in the all-product category are at the opposite end of the scale. As a category, principal-protected notes scored quite well in our system," she said.

With its probability chart, Future Value Consultants estimates how the product is expected to perform under the optimal market assumption.

With the bull market assumption, there is a 49% probability for an annualized return comprised between 0% and 5%. The chance of getting a 5% to 10% gain per annum is 42%. The probability associated with the 10% to 15% return bucket is 9%.

Price score

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

At 9.92, the price score is a little bit higher than the 9.40 average for the same product type.

"Long maturities always improve a price score. You also have a 100%-110% range for the participation rate. If it turns out that the gearing is only 100%, you would expect the price score and the return score to fall," Hampson said.

Overall score

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The score is simply the average of the price score and the return score.

The overall score for the notes is 9.20, which is higher than the average for the typical principal-protected notes of 8.82. The score is also considerably better than the average for all products of 6.80, she noted.

"It's a great overall score. It's above average by all measures. There's nothing that would put an investor off in this structure. The only thing would be the averaging," she said.

"We run a Monte Carlo simulation to calculate the return score. We take into account averaging calculation as we look at each quarter rather than looking at the last point of return.

"The averaging makes the option cheaper. You're still getting value for your dollars. It enables you to have this 110% participation.

"It's just another feature issuers will use to structure a product. It's not necessarily bad. It just needs to be understood by the investor.

"But as far as the score goes, the product is quite competitive."

The notes (Cusip: 94986RQX2) will price Aug. 30 and settle Sept. 9.

Wells Fargo Securities LLC is the agent.

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