Deutsche Bank's PowerShares QQQ notes offer opportunity to beat Nasdaq 100, analyst says

By Emma Trincal

New York, Dec. 4 - Investors moderately bullish on the Nasdaq 100 index may expect to significantly outperform the non-financial large-cap stocks benchmark with Deutsche Bank AG, London Branch's offering of enhanced participation notes due Dec. 23, 2011 linked to the PowerShares QQQ trust, series 1, said structured products analyst Suzi Hampson at Future Value Consultants.

The notes offer a return at maturity of two times the appreciation of the PowerShares QQQ Trust.

PowerShares QQQ is an exchange-traded fund that that tracks the performance of the Nasdaq 100. This index includes 100 of the largest domestic and international non-financial securities listed on the Nasdaq Stock Market.

The payout at maturity will be par of $10 plus 200% of any increase in the ETF share price, subject to a maximum return of 26% to 32% to be set at pricing. Investors will receive par if the share price remains the same. But they will lose 1% for every 1% that the underlying declines below its initial level.

Moderate bulls

"For a stock investor or fund investor, these notes offer an excellent way to significantly outperform the ETF given the 200% participation rate," said Hampson.

But Hampson pointed to the cap as an important feature investors may want to consider carefully. She assumed the maximum return would be established at 29% for demonstration purposes, just in the median of the 26-32% range.

A 29% cap for two years would represent an annualized return of 14.5%.

"This cap illustrates that the product is only suitable for those who are moderately bullish on the performance of the underlying. If you anticipated a strong market growth of 50% for instance, then these notes would not work for you and you would be better off buying the PowerShares directly," she said.

Overlooked underlyings

Hampson said that the PowerShares QQQ and the Nasdaq 100 are "similar" with the ETF replicating the index. As a result the two assets were "fairly interchangeable."

Both the ETF and the index are "quite volatile" she said, with their annualized volatility 42% and 43% respectively, she calculated.

Another similarity between the Nasdaq 100 and the PowerShares QQQ as underlying assets is that "they are not very popular," she said. "I haven't seen this index or the ETF replicating it very much used in deals," she said.

The Deutsche Bank enhanced notes linked to the PowerShares QQQ are only the third U.S. deal that employs this underlying so far this year, according to data compiled by Prospect News. The two prior ones were very small in size.

Barclays Bank plc priced $1 million of notes linked to the PowerShares QQQ in July. In September, Royal Bank of Canada sold $2.1 million. When it comes to deals referencing the Nasdaq 100, only one deal came to market this year in the United States, according to Prospect News data.

"It's hard to explain why some indexes are hardly used while the S&P 500 is so common," said Hampson. "I don't think it's because the Nasdaq 100 has only 100 stocks while the S&P 500 is broader, because the use of FTSE 100 is very much common," said Hampson. "I think it has more to do with the visibility of the S&P 500. It's very liquid, options trade on it all the time, so you can get more competitive pricing."

Risky structure

Hampson emphasized the "fairly high risk" of the structure.

"If your index finishes below the initial level, you are completely exposed to the downside," she said.

"The riskmap is very high because your principal is not protected at all. Usually, you can expect some sort of downside protection, but here you have nothing: no buffer, no barrier."

Riskmap is a Future Value Consultants' rating that measures the risk associated with a product on a scale from zero to 10. The product has a 7.21 riskmap, according to the firm's research.

However, Hampson said that a particular category of investors may be "glad" to take that risk.

"If you are someone, a stock investor who is used to investing in the stocks directly or in the ETF without any protection then you're not more exposed with these notes than you would be investing in the underlying directly," she said.

"And you might appreciate the 200% gear. If your fund grows by 10%, you get 20%. Your return is capped, but the structure meets the need of a moderately bullish investor," she noted.

Risk is reflected and illustrated by the probability of returns, added Hampson.

Investors have a 53.60% probability of getting a 10% to 15% return per annum, according to Future Value Consultants' research.

But on the downside they are taking on principal risk, Hampson added, with a 34.2% risk of losing more than 5% of their investment.

Good overall score

The overall rating of this structure - at 7.69 - is "good," said Hampson, "essentially due to the high value return."

The overall rating, on a scale of zero to 10, is the firm's opinion on the quality of a deal, while the value rating, one of the main components of the overall rating, measures on the same scale how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

The Deutsche Bank enhanced notes in this case have a 9.84 value rating. "This very good value rating shows that the issuer has spent a lot on the assets and has not taken much fees," Hampson said.

Average return

The return rating, which measures on the same scale of zero to 10 the risk-adjusted return of the notes is in this example "in the middle" said Hampson pointing to a score of 5.15. She said that this score may be attributed to the fact that the returns are capped and also due to the "fairly high" level of risk, which affects the risk-adjusted return rating.

The notes are expected to price on Dec. 18 and to settle on Dec. 23.

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