Goldman's leveraged notes linked to iShares MSCI EM ETF are rebound play on emerging markets

By Emma Trincal

New York, Aug. 8 - Goldman Sachs Group, Inc.'s $5.34 million issue of 0% leveraged buffered notes due Aug. 6, 2015 linked to the iShares MSCI Emerging Markets exchange-traded fund was seen as an efficient way to express a contrarian view on an out-of-favor asset class or to enable mildly bullish investors to capture enhanced gains, sources said.

In both cases, the downside protection appeared sufficient given today's negative performance of the underlying fund as well as positive economic growth expectations.

The payout at maturity will be par plus two times any fund gain, up to a cap of 30%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by up to 10% and will be exposed to any losses beyond the 10% buffer at a rate of 1.1111% per 1% decline.

Underdog

Steve Doucette, financial adviser at Proctor Financial, said that the structure was attractive for a contrarian play.

"The two-times leverage is good, and this is emerging markets, which are falling on their face, so it makes the 10% buffer pretty reasonable given how bad the performance of emerging markets has been recently," he said.

The underlying fund has declined by 11.5% year to date. It is down 2.5% from a year ago.

In comparison, the S&P 500 has gained 19% for the year and is up 21% over the past 12 months.

If emerging markets have underperformed U.S. equities so far in 2013, Doucette said that a trend reversal could be expected.

"Returns have not been good in the space, but it doesn't mean that the downward trend is going to last forever unless you think that everything is going to go down in the next two years," he said.

The upside potential of emerging markets will depend a lot on growth, he noted.

"It's a pretty decent note except if you have a bearish view over all equity markets for the next two years," he said.

"I think we still have reasonable valuations in the equity market and that the economy is showing signs of life as you can see with the housing recovery or the pickup in auto sales, among a number of things that should lead us forward. If the global economy improves, every market will do better and that includes emerging markets, which do quite well when economies are in recovery mode."

Betting on growth

Even if global growth remains slow, the combination of leverage and a 30% cap made the upside attractive, he said.

"A 30% cap over two years, that's pretty good I would say. Who's going to argue about a 15% a year return?"

As emerging markets have significantly underperformed U.S. equity markets, investing in the asset class warrants close attention, he added.

"It's a bit of a contrarian play. But look at it that way: The best returns are typically going to be in the asset class that has underperformed," he said.

"There is safety and security in the U.S., but the U.S. market has run so far, so fast, you have to ask yourself how far it's going to continue to rally.

"Part of the answer depends on our economy. If the U.S. economy continues to pick up, the global recovery will pick up and the world will benefit from that, including emerging markets."

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said that the notes were appropriate for investors who expected a rebound in emerging markets but at a moderate pace.

"It's interesting to look at an entry point with a structure like this one. Having some upside enhancement and a modest buffer on the downside makes it quite compelling," he said.

"It seems to me that the emerging market investment theme is making a comeback. A lot of the recent underlyings we've seen in structured notes have been in the emerging markets asset class. A lot of people have exited emerging markets after the first quarter of the year. Now it looks like they're re-entering the space."

Cautiously bullish

The structure, he said, could be used by mildly bullish investors.

"From the upside perspective, I don't think that emerging markets will have a record-setting year, so having the return enhancement is nice," Medeiros said.

"The 10% buffer is sufficient relative to where emerging markets are now. Even though the S&P has had a substantial run, emerging markets are trading essentially where they were a year ago.

"For someone who is not aggressively bullish, getting the leveraged return with a decent cap is a good thing.

"And from the downside standpoint, I don't see a big pullback from where prices are right now. We've already seen some substantial declines, so I don't anticipate something drastic."

Medeiros said that the underlying fund was also attractive for its weightings.

"Some of this fund's weightings are interestingly similar to the S&P," he said.

"If you look at the S&P, some of the major drivers are coming from the financial sector just like it did in 2012, and the emerging markets index is substantially weighted in the financial sector as well."

Financial stocks make for the iShares MSCI Emerging Markets ETF's largest allocation with a 27% weighting.

"As emerging markets become more competitive in the next few years, they'll see their financial sector grow. It's necessary to have a strong financial system if you want to participate in the global growth," he said.

"I'm not very bullish on emerging markets. I'm not bearish either. But being able to play a slight underweight in emerging markets through a position in a structured note seems to make a lot of sense.

"With the return enhancement you get from the leverage and the downside protection from the buffer, you can get exposure to this asset class with a slightly different risk return profile than if you had bought the fund directly."

The notes (Cusip: 38147QKJ4) priced on Aug. 2

Goldman Sachs & Co. was the underwriter.

The fee was 0.36%.

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