GS Finance’s leveraged buffered notes linked to Nasdaq-100 have low cap given volatile index

By Emma Trincal

New York, May 17 – GS Finance Corp.’s 16-month 0% leveraged buffered notes linked to the Nasdaq-100 index offer both some leverage and a buffer, which is attractive on a short-dated note, financial advisers said.

Unfortunately, the range between the buffer and the cap is too narrow given the high volatility of the underlying index. The result is not enough potential return as well as too little protection on the downside if the index moves one way or the other, they noted.

The notes are guaranteed by Goldman Sachs Group, Inc., according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is positive, the payout at maturity will be par plus 150% of the index return up to a maximum settlement amount of $1,150 per $1,000 note. Investors will receive par if the index declines by 10% or less and will lose 1% for every 1% decline beyond 10%.

Volatile index

Jerry Verseput, president of Veripax Financial Management, said someone investing in the notes would have a reduced chance of making the right bet because the range of positive outcomes is too narrow.

“I would be hesitant on this note. If the market is good, this Nasdaq 100 could go up much faster than 11% per year,” he said.

Based on the leverage factor, term and cap, the note can deliver up to 11% a year on a compounded basis.

“You would really need to be making a bet that the market is not going to have a good year. The range where you won’t regret having purchased this note is very narrow,” he said.

This problem is made worse by the nature of the underlying index itself.

The Nasdaq-100 includes 100 of the largest domestic and international non-financial stocks listed on the Nasdaq stock exchange, which is home to more than 3,700 listed companies.

The top holdings in the Nasdaq 100 are Apple Inc., Alphabet Inc., Microsoft Corp. and Facebook Inc.

The index components are mainly stocks of companies operating in volatile sectors, such as biotechnology or technology. As a result, the index is highly volatile, he noted.

“If the index drops 25%, you only lose 15%. You’ll still kind of regret that you made that bet.

“It’s only between negative 10% and positive 10% ... then you’re in the right range. No regrets. But with that type of volatility, it’s a pretty narrow range.”

Narrow range of success

Verseput pointed to the downside risk, which he said was his main concern.

He said he does not believe a 10% buffer would be enough to protect investors from hefty losses in a downturn scenario given the wide moves of the underlying index.

In 2008 for instance, while the S&P 500 index lost 37%, the Nasdaq-100 index declined by more than 45%.

The next year, the S&P 500 gained 26.5% while the Nasdaq-100 surged 80%.

Part of what makes the “range of success” too narrow is the short tenor, he said. In addition, there is no real reason, in his view, to keep the duration so short.

Too short

“Buying a note like this one is purely equity replacement. If you’re going to have a stock exposure, you should have a longer timeframe than 16 months,” he said.

“The longer the duration of a note, the more protection they can put into it.”

If having a short-term note means taking on excessive risk on the downside, then the trade-off is not interesting in his view, first because a short duration is not required and second because the risk is poorly mitigated.

“This note doesn’t really fit into a logical strategy,” he said.

“If my typical timeframe for equity exposure is at least five years, I would much prefer getting five years’ worth of protection as opposed to doing this 16-month [note] with only 10% on the downside.

“If what it takes to get 40% to 50% in downside protection is a five-year term, why not do that over five years?

“On a five year, I would expect no cap and at least 40% on the downside. Issuers can price deeper barriers when they extend the length of a note. I would want to take advantage of that rather than taking too much risk on the downside just to keep it short.”

Cap

Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, said a few features of the product are acceptable except the cap.

“For starters, we have no problem with Goldman Sachs’ credit. A short-term note is fine. The 16-month [term] is long enough to get the benefit of the long-term capital tax treatment. Obviously, having a leveraged note is something we like as well as some kind of a buffer,” he said.

These are the good aspects of the deal.

“What we don’t like is to take a volatile asset class –and this index is already down 5% year to date – and eliminate the possibility of a substantial return for the client because the gains are capped at 15% for the period,” he added.

“I have no problem with 11% per year. However – and that’s why I wouldn’t buy the notes – I have a problem with capping a volatile asset class and not being able to get the full benefit of the return.”

In recent years, the Nasdaq-100 posted high returns, he noted, pointing to a 38% gain in 2013 and a 25% positive return in 2014.

Upside risk

“The idea of capping it at a pretty low number over 16 months is not the type of thing we would want to do.”

Even the buffer amount does not justify limiting the upside by that much, he noted.

“For a 10% buffer you’re giving up the results and of course the dividends, so more than 2% in 16 months,” he said.

“You’re getting the leverage but only to a point. It may work if the index has very modest returns, and I guess it has to be your view as an investor.

“If I had to redesign the notes, I’d like more upside. I may have to go further out. But as it is, the cap is way too low and you’re not getting a huge amount of protection.”

Goldman Sachs & Co. is the agent.

The Cusip number is 40054KCN4.

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