Goldman Sachs notes comparison shows investors should examine cap, volatility, analyst says

By Emma Trincal

New York, Nov. 6 - Two very similar products, but with slight differences in structure and volatility, may lead to very different risk-return profiles, said structured products analyst Suzi Hampson at Future Value Consultants.

Hampson compared two equity buffered notes. Both had a two-year tenor and both were recently announced by Goldman Sachs Group, Inc. in 424B2 filing with the Securities and Exchange Commission.

MSCI and S&P mix

The first deal offered notes tied to a basket of two indexes, with the MSCI EAFE composing the majority of that pool. The basket consisted of the S&P 500 index with a weight of 25% and the MSCI EAFE index with a weight of 75%.

The payout at maturity for this announced transaction will be par plus 1.5 times any gain in the basket, up to a 22.5% cap. The structure featured an 11.5% buffer. Investors will receive par if the basket falls by less than 11.5% and will be exposed to losses beyond 11.5%.

"Structurally, what you have here is a 22.5% cap, which limits potential returns; and you have a 150% participation rate; you also have a less volatile underlying than the MSCI only since the S&P 500 index has been thrown into the mix," Hampson said.

MSCI only

By comparison, the second deal consisted of two-year 0% leveraged buffered equity index-linked notes tied to the MSCI EAFE index.

"Without the S&P, you have a more volatile structure here," Hampson said.

For this transaction, the payout at maturity will be par plus any gain in the basket with no cap. There is a higher buffer set at 14%. Investors as a result will receive par if the basket falls by less than 14% and will be exposed to losses beyond 14%. As always, the higher buffer represents more protection.

Volatility and risk

Hampson first looked at the risk profiles for both transactions.

The notes tied to the emerging market index only are "riskier," she said, with a 6.10 riskmap versus 4.71 for the other structure. Riskmap is Future Value Consultants' rating, which measures the risk associated with a product on a scale from zero to 10.

"This result comes from the differences in the underlying volatilities," she said. "Historically, the MSCI EAFE has been far more volatile than the S&P 500. By introducing the S&P 500 into the mix, the structurers have reduced the volatility. You get a lower riskmap with the notes that include the S&P 500 in the underlying basket."

Buffer less relevant

Hampson noted the following paradox: The notes with the most protective buffer (14%) were actually the riskiest.

Inversely, the deal with the lower buffer, which means the lower level of protection, happened to score the lower riskmap.

Hampson offered an explanation: "Despite the structure, volatility of the underlying is a prevalent indicator of risk," she said.

"The mere fact that the underlying mix is more volatile still means a higher riskmap. The higher buffer is not quite enough to compensate for the differences in volatility," Hampson said.

The annualized historical volatility for the MSCI and S&P 500 mix is 35.47%, said Hampson. It is less than the MSCI-only underlying whose annualized historical volatility is 37.97%.

"The difference in volatility between the two underlyings would have been much more striking if the S&P 500 had been more in weighting. But it's only 25% of the basket," Hampson noted.

Concluding on the risk, Hampson said that investors should look beyond the structure when picking an investment. She stressed that underlying volatility was an important risk factor that should be considered.

Cap of no return

This picture changes when one looks at returns. Hampson, pursuing her comparison, said when one looks at return probabilities, structural differences were the most important key factor, at least in this example.

The structure linked to the MSCI EAFE index had a return probability greater than the other, less volatile deal. The first one scored a 7.38 return rating versus 5.55 for the transaction including the S&P 500 index in the underlying basket.

The return rating is Future Value Consultants' indicator, on a scale of zero to 10, of the risk-adjusted return of the notes.

Hampson said that in this case, it was the absence of a cap rather than the more volatile underlying that drove the higher returns.

"What matters here is that one transaction is capped while the other is uncapped. The capped deal is the one that has no probability of high returns, by definition. Your chances of earning more than 22.50% are zero," Hampson said.

Hampson looked at the probability table of return outcomes, saying that the chances for the notes tied to the mixed basket of getting more than 15% in annualized return were 38.5% versus none for the capped deal.

Hampson noted that the existence of a 150% participation rate, or 1.5 times leverage, was not enough to counter the dampening effect of the cap on returns.

Expressing views

"I don't think the underlying volatility plays a substantial role here. That's because the S&P 500 weighting is only 25%. If it had been a 50%/50% mix it would have been different," she said.

However, Hampson said that "by introducing the S&P 500 into the mix, you can attract investors who are familiar with the U.S. equity index and who would have been unlikely to invest in a very volatile index only."

But she added that the structure with the most volatile underlying (MSCI index only) was also the one which gave investors the best terms.

"If you were really bullish on emerging markets, you would want to go with the uncapped deal. If you saw the index was going to grow, you would want the whole growth," she said.

Cap and underlying

Finalizing her analysis, Hampson compared the two deals in terms of their respective overall rating.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal. It takes into account costs (value rating); structure (simplicity rating); and risk-return profile (riskmap and return rating).

The notes linked to the MSCI EAFE index scored the best with an 8.44 overall rating versus 7.70 for the other structure.

"This really boils down to returns," said Hampson. "The best rated deal is the one with the highest probability of returns. If you look at both structures their value rating is the same; their simplicity rating is the same. The difference is in the returns," she said.

Conclusion

The conclusion of this comparison, said Hampson, is that underlying volatility was an important factor determining risk while the elimination of a cap is perhaps the most basic way to increase returns.

Goldman Sachs & Co. is the underwriter.

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