Goldman’s $38.8 million notes linked to MSCI Italy stocks feature new rules of basket design

By Emma Trincal

New York, June 13 – Goldman Sachs Group, Inc.’s $38.8 million of 0% notes due Dec. 15, 2015 linked to a basket of the shares of the 24 Italian companies included in the MSCI Italy index caught the market’s attention for the underlying basket used in the structure.

The basket replicates the list of the stocks populating the MSCI Italy index. The difference is in the weightings, according to a 424B2 filing with the Securities and Exchange Commission.

“They just took the universe of the index and then changed the capping,” a market participant said.

The basket was selected on June 4 and includes all of the constituents of the index at that time, according to the prospectus.

It is comprised of 26 ordinary shares and savings shares of the 24 companies included in the index.

Because the weightings in the basket are different than those applied in the index, the performance of the basket may not correlate with the performance of the index, the prospectus warned.

Concentration risk mitigation

But sources explained that the “reweighting” was probably not designed to give a strategic edge to the basket but rather was done in an effort to limit concentration risk.

The calculation agent took the weights of the stocks in the index and reweighted them so that no basket stock was weighted in excess of 5% of the basket, the prospectus said. The weightings of the shares range from 0.325% to 5%.

“They take the stocks of the MSCI Italy index and apply different weighting schemes,” the market participant said.

“The MSCI Italy has a high concentration in a few stocks. The five highest weighted stocks represent almost 60% of the index and are mainly from the financials, energy and utility sectors. Therefore, it makes sense for an investor that is looking for a broad exposure to Italy to cap each individual stock at 5%.

“Eni, for instance, the top company, has a 19% weighting. It’s like having a single-stock risk in the index.

“Suppose their stock goes down 10%. Your portfolio is down 2% although there are 23 other companies.

“That’s what happens if you buy the index as it is. To avoid that, the investor looks for a cap of 5% for each stock.

“As the index tracks 85% of the large-cap Italian stock market, you still keep exposure to this market, but you cap the weightings.

“This note was obviously designed for an investor who likes Italy as a market but doesn’t want to live with concentration risk in his portfolio.”

Eni SpA is an energy company.

Not your usual basket

Many structured notes are built around a basket that is comprised of stocks selected from an index, sources said.

What makes the choice of this basket different is that it duplicates the universe of the index, the market participant said.

“Sometimes people select stocks with the highest dividends or the lowest beta or any other investment filter. But it’s not the case here since they’re using all the original constituents,” the market participant said.

“It might be a requirement from the client. In fact, it looks like this is a customized deal that would have been done for an RIA who would have bought it for its investors and redistributed it among several accounts.”

This market participant said the concept and methodology used in the creation of the underlying basket are unusual.

“I haven’t seen it done like that, not in such a direct way, like taking all the constituents and just reweighting them,” he said.

“What they usually do in structured products is to take an index and to select a number of stocks within the index – not all of them – according to some criteria. Most of the time, they pick filters based on performance or liquidity. It varies. But once they pick, say, 20 stocks, they give them a 5% weighting each.

“This is slightly different. They’re not picking stocks. They’re changing the weightings to minimize the impact of one single stock on the group. And secondly, it’s not equally weighted. The cap of 5% applies to all of them, but there is no equal weighting. This is not much more complicated to calculate than a straight basket carved out of an index. But it’s rather unusual.”

For each basket stock having an initial weight of more than 5%, the excess weight was distributed to each of the other non-capped basket stocks pro rata according to their initial weights such that no basket stock would be greater than 5%, according to the prospectus.

One-to-one

Sources noted that baskets are used not only to put together a portfolio but also for option pricing efficiency.

But the structure employed in the product is delta one.

The payout at maturity will be par plus the basket return. If that return is negative, investors will receive less than par, according to the prospectus.

The issue price was 99.18% of par.

“There are no options to worry about, so this is not done for more pricing or hedging as it happens sometimes when you put together a basket of stocks,” said Tim Mortimer, managing director at Future Value Consultants.

“Usually, [the] issuer wants the most liquid stocks to be able to trade them in and out at the best possible cost and to facilitate hedging. But apparently, it doesn’t seem to be the case here.”

Go Italy

Another particularity of the deal – whose size is “not negligible,” according to a source – is the underlying bet on a single country in Europe.

“That’s a play on the European recovery,” a sellsider said.

“In Europe, the southern countries are starting to do better than the big ones like France or Germany.

“I bet they will do another deal like this one, either on Spain or Portugal or both.”

Ferenc Sanderson, partner at PrevInvest, a pension and research advisory, said, “There is growing confidence among investors in Europe that the current restructuring and liberalization effort in Italy will have a positive impact on the economy.

“Just as an example: in a couple of months, a new law in Italy is expected to allow all public pensions to invest up to 20% of their assets in alternative asset classes. Right now, they are prohibited from investing in hedge funds or private equity. This law if it passes will be a big bang for institutional investing. Such change would shake up the investment landscape and contribute to boost the economy as well.”

The MSCI Italy index is up more than 15% this year. The MSCI Spain index has gained 13%. Based on the same series of MSCI indexes, Germany is flat, France is up 5.75% and the United Kingdom is up about 4%. The Euro Stoxx 50 index has increased by 5%.

“Italy, Spain and Greece have been badly hit by the sovereign debt crisis three years ago, but it looks like they’re slowly recovering,” Sanderson said.

“If you were a value investor looking to invest in Europe, you would be drawn to distressed, undervalued countries such as those southern countries. You could buy Germany or the U.K., which are further ahead in their cyclical improvement. But you would probably look for value first. That’s what this investment is about.”

The notes (Cusip: 38148C239) priced June 10.

Goldman Sachs & Co. was the underwriter.

The fee was 0.85%.

According to the prospectus, the underlying shares in the basket are Assicurazioni Generali SpA (5% weight), Atlantia SpA (5% weight), Banca Monte dei Paschi di Siena SpA (2.138% weight), Banco Popolare (4.274% weight), CNH Industrial (5% weight), Enel Green Power SpA (3.154% weight), Enel SpA (5% weight), Eni SpA (5% weight), Exor SpA (2.605% weight), Fiat SpA (5% weight), Finmeccanica SpA (2.173% weight), Intesa Sanpaolo SpA ordinary shares (4.675% weight), Intesa Sanpaolo SpA savings shares (0.325% weight), Luxottica Group SpA (5% weight), Mediobanca Banca di Credito Finanziario SpA (3.803% weight), Pirelli & C SpA (2.53% weight), Prysmian SpA (2.913% weight), Saipem SpA (4.472% weight), Snam SpA (5% weight), Telecom Italia SpA ordinary shares (3.412% weight), Telecom Italia SpA savings shares (1.588% weight), Tenaris SA (5% weight), Terna Rete Elettrica Nazionale SpA (5% weight), UniCredit SpA (5% weight), Unione di Banche Italiane ScpA (5% weight) and Unipolsai SpA (1.938% weight).

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