Goldman's leveraged notes tied to iShares MSCI EM target those seeking value, diversification

By Emma Trincal

New York, Dec. 22 - Goldman Sachs Group, Inc.'s 0% leveraged buffered index fund-linked notes tied to the iShares MSCI Emerging Markets index fund are part of a recent inflow of notes that offer investors exposure to emerging markets, a sector many find attractive again due to its low valuation and potential for growth and diversification, sources said.

The notes are expected to mature 13 months after issue, according to a 424B2 filing with the Securities and Exchange Commission.

If the fund gains, the payout at maturity will be par plus double the fund return, subject to a maximum payment of $1,260 to $1,300 per $1,000 principal amount. The exact maximum payment will be set at pricing.

Investors will receive par if the fund falls by up to 10% and will lose 1.1111% for every 1% decline in the fund beyond 10%.

Signs of interest

Early last week, JPMorgan Chase & Co. priced $50.3 million of 0% capped index fund knock-out notes due Dec. 26, 2012 linked to the iShares MSCI Emerging Markets index fund. It was second-largest offering of the week.

Since the beginning of the month and as of Thursday, agents have sold $80 million of notes linked to this exchange-traded fund, which has the NYSE Arca ticker symbol "EEM." It represented nearly 7% of the volume sold in December against 0.5% for the same period in November.

Cheap

Since its peak in April, the ETF has lost 24% of its value, scoring its low for the year in the beginning of October.

At $38.35 a share on Thursday, the ETF is only trading five points over its 52-week low. Its price-to-earnings ratio is 8.

"There seems to be more attention to emerging markets," said Richard Kang, chief investment officer at Emerging Global Advisors.

"Emerging market prices have gone down hard, and so investors are trying to figure out if it's a good entry point.

"There has been a big flight to quality, which explains the dollar spike and with that the falling prices in this sector. It led some people to re-enter the market and establish a significant exposure to emerging markets, which is probably why you see a lot of structured products around them."

Where else?

Another factor for this renewed interest may be that news in developed countries is far from positive, he noted, making emerging markets more appealing than before as a diversification tool.

"Investors are piling on emerging markets because they see more opportunity for yield and growth in these countries than in the U.S.," said Kang.

"Typically, people go to Europe and Japan when they want to diversify away from the U.S.

"But Japan has been fighting a continuous deflation for the past 20 years. And the outlook in Europe is even worse with the euro zone crisis.

"Europe and Japan are the opposite of diversification. They're doing as bad as the U.S. if not worse.

"And since U.S., Europe and Japan are harder places to put your money in, it makes sense for some people to get emerging markets exposure."

Debatable proxy

But Kang said that for emerging markets exposure, other underlying securities are more adequate than the one used in the notes.

"I would question why investors would use EEM as a proxy for emerging markets," he said.

"Among the five top countries in the index - China, Brazil, South Korea, Taiwan and South Africa - two are not considered emerging markets," he said.

He referred to the International Monetary Fund classification that excludes Korea and Taiwan from its definition of emerging market countries based on a set of rules such as GDP per capita.

Looking at the top stock holdings in the index, Kang pointed to the overweight in Samsung Electronics Co., Ltd., which, he noted, represents 3.23% of the total, or nearly twice the allocation of the next biggest position.

Given the successful international expansion of Samsung - the company sells semiconductors globally and components for iPads - he said that it was questionable whether the South Korean electronics conglomerate had its place in the index.

"Based on the benchmark's geographic allocation and stock picks, it seems that EEM may not be the best proxy for emerging markets exposure," he said.

Kang disclosed that his company launched last summer an ETF that competes with the iShares MSCI Emerging Markets index fund, the Low Volatility Emerging Markets Dividend ETF. It is designed to provide high dividends and less volatility through the selection of low-beta stocks.

Risk/return profile

Steve Doucette, financial adviser at Proctor Financial, said that the notes fit the current sense of conviction seen among investors. For true bulls, though, the investment offers little value due to its limited upside and insufficient downside protection.

"I tend to think that if there's going to be growth in the world economy, a lot of it will come from emerging markets," said Doucette. "This note is for people who are still uncertain."

But Doucette said that the downside protection was disappointing.

"A 10% downside is almost pure market exposure. On a very volatile asset class like that, it's not a huge buffer," he said.

The risk/return profile could have been better too, he said, considering the fund's potential for big price swings.

With these notes, a 26% to 30% cap on the 13-month term is the equivalent of a 24% to 27.7% annualized return.

"Maybe you're looking at 50% upside, who knows? So this thing caps your upside with very little downside protection. If you're really bullish, it's not going to work for you," he said.

Doucette said that the trade was the equivalent of a "straddle."

In option terminology, a straddle means the purchase or sale of an option in order to gain from the underlying no matter which direction its price goes to.

The sale of a straddle would involve selling a put and a call at the same time, with the same terms, which is close to what the structure does, he explained.

The put sale is what triggers the loss of capital once the 90% strike price is hit. The call sale is what limits the upside above the 130% cap.

The buffer level and cap level in the structure are not exactly at the same level, but the concept remains the same.

"This is very similar to a straddle," said Doucette.

"You're trying to pick up on either side. It's what a lot of people are thinking, I suppose, and that's probably why these things are so popular. They don't know where the market is going, so they take a little bit on either way. These are not very creative structures in my view.

"I'd look at a better risk/return in the space, ... something that would let me take advantage of the fact that emerging markets have the potential to outperform."

Doucette said that he has funds allocated to emerging markets as he is cautiously bullish on the asset class.

"We always have a position in emerging markets. It's a question of how much," he said.

The Cusip number is 38143UK67.

Goldman Sachs & Co. will be the underwriter.

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