HSBC’s $470,000 lookback allocator notes linked to three indexes seen as ‘unique’ structure

By Emma Trincal

New York, Sept. 25 – HSBC USA Inc.’s $470,000 of 0% lookback allocator notes due June 26, 2019 linked to the S&P 500 index, the Euro Stoxx 50 index and the Hang Seng China Enterprises index modify the weightings of each index return in a way designed to enhance performance, a structure that sources said is uncommon.

The payout at maturity will be par plus the allocated return, which is 60% of the highest index return plus 30% of the second-best index return plus 10% of the lowest index return, according to a 424B2 filing with the Securities and Exchange Commission. The allocated return can be positive or negative.

“It’s obviously a unique structure. I haven’t seen it before, frankly,” said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

“At the same time, it’s a relatively long period of time.

“But the structure is interesting. It offers you some diversification, which is good. It also enables you to optimize your allocation.

“The broader indices are more appealing to me than sector indices.”

The allocation method ensures that the index with the best performance will have the greatest weighting while the index with the worst performance will have the lowest allocation, according to the prospectus.

But the prospectus also states that investors may still lose all or some of their investment if the best index performance is not sufficient to counterbalance the negative returns of one or both of the other indexes.

The notes offer no upside leverage and no downside protection. Whether the minimal allocation to the worst-performing index is a form of risk mitigation is debatable, according to the sources.

“I like the fact that it’s a five-year. I think it takes away the risk of any kind of near-term correction. Five years is a good window for the stock markets,” said Jim Delaney, head trader of Market Strategies Management.

Boosting returns

Delaney said that the allocation embedded in the notes is a return enhancer.

“If you go 100% U.S. market, you might underperform. The fact that you’re doing 60%, 30% and 10% is a good way to blend those three indices. I suspect all three will be in positive territory five years from now. They gave you a majority of the winner and you follow with the other two’s.”

Investors with a positive outlook on the U.S., European and Hong Kong stock markets would benefit from the 60% allocation to the best index without having to worry too much about the least-performing market, he explained.

“If you are in any way bullish on the global expansion in the next five years, which I think you have to be, then this is a good piece of paper for a retail buyer,” he said.

“You could see it as a substitute for a downside protection. In my view, over the next five years all three indices will be higher. But it’s still good to know that the worst of the three will only get 10% of the allocation while you still have exposure to three benchmarks.”

The structure offers another advantage: protection for investors and asset allocators from emotions known to generate losses.

Greed and fear

“The big two as we all know are greed and fear,” he said.

“Once you do your allocation and the result turns out to be different from what you expected, it’s easy to say, ‘I wish I would have done more of this and less of that.’

“With this note, at least you know that 90% is going to be with the two best things. You only get dragged back by the third one for a small 10%.

“In my view, in five years, the U.S. will be back on its feet. Europe should be out of its current malaise. China is going to [be] China. They’ll continue to grow even if they go through a short-term correction. The lag is Europe.

“If the notes were to mature now, you would get 60% of the return from the U.S., 30% from Asia and 10% from Europe. It doesn’t mean that this is going to be what you’ll get in five years, but you know that you have at least some of the best and the least of the worst. I kind of like it.”

Diversification

Medeiros said that investing in the notes requires first that investors be comfortable with the three underlying indexes.

“We are relatively optimistic with these indices. This deal looks like something set up to achieve decent returns through diversification,” he said.

The structure’s benefit is in the allocation feature, not so much in the terms, as the product lacks any form of downside protection or leverage, he noted.

Medeiros said that the small allocation percentage to the worst-performing index is not a substitute for a traditional downside protection feature.

“The fact that the notes will only allocate 10% to the worst index is not in my opinion a substitute for a downside protection. I don’t see it as a defensive feature. It’s just another way to optimize your allocation, your return. You benefit from the best performer as you get the highest percentage allocation from it. It’s less of an allocation and more of an attribution,” he said.

With their rules-based allocation based on performance, the notes are more of a handy tool for an asset adviser, he continued.

Decision-making helper

“You can benefit from the best performer without having to make the decision from the beginning,” he said.

“The 10% allocation to the lower performance is not necessarily a form of risk mitigation. What it does is minimize the work to be done when it comes to forecasting future returns. I really don’t have to spend a lot of time trying to optimize my asset allocation if I choose these three indices. I’m not sure I’m taking more risk or less risk. It just eliminates the need to make the perfect decision. Of course, you must be willing to get exposure to those three indices.

“Generally speaking, when I look at a structured note I want to see some form of downside protection.

“In this case, I focus less on the downside protection because I have minimal exposure to my worst-performing asset.

“The risk is the risk, but I’m certainly more comfortable having no downside protection with this type of structure.”

The main drawback for Medeiros is the duration of the notes.

“It’s an interesting core to a portfolio, but I wouldn’t be putting a great deal of allocation toward it, primarily because it’s very long-term in nature,” he said.

The notes (Cusip: 40433BLF3) priced Tuesday.

HSBC Securities (USA) Inc. was the agent.

The fee was 2%.

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