Advisers skeptical about hedging value of JPMorgan’s $7.56 million knock-out notes tied to gold

By Emma Trincal

New York, Nov. 4 – JPMorgan Chase Financial Co. LLC’s $7.56 million of 0% knock-out notes due April 30, 2021 linked to gold offer a non-conventional payout. Investors are guaranteed not to lose more than 4% of principal, and the upside will always be capped at two different levels depending on the occurrence of a knock-out event, according to a 424B2 filing with the Securities and Exchange Commission.

Advisers were skeptical about a somewhat “complex” structure that in their minds failed to maximize the hedging benefits of gold.

A knock-out event occurs if, on any day during the life of the notes, the price of gold is greater than its initial value by more than the knock-out percentage, which is 30%, according to the prospectus.

Investors at maturity will receive 96% of par, which may or may not be offset by the commodity price appreciation. But at no point will they lose more than 4% of principal.

If a knock-out event has not occurred, the payout at maturity will be 96% of par plus the return of the commodity, subject to a minimum commodity return of zero. In order to get a positive return, the spot price of gold has to appreciate by more than 4%. The upside above par will be capped at a 26% gain since by definition, the price of gold has not increased by more than 30%.

If a knock-out event has occurred, the payout will be $1,110.50 per $1,000 principal amount of notes.

Upside risk

Michael Kalscheur, financial adviser at Castle Wealth Advisors, noticed the strong impact of the occurrence of the knock-out on the height of the upside cap.

Investors can be capped at 26% if gold never goes up more than 30%. But if it does, the cap drops to 11% for the 18-month term, he said.

“If gold is up 31%, there’s a knock-out and I get 11%. I don’t think so,” he said.

To be sure, the knock-out event could happen early on followed by a strong decline in gold with a negative value at maturity, allowing investors to strongly outperform with the fixed payment of 11.05%.

Alternatively, gold could end up positive yet still lower than 11.05%, giving investors a chance to outperform in a similar way as with a digital payout.

But Kalscheur was not convinced since the knock-out requires a solid jump of 30%.

“You’re not guaranteed to underperform because this knock-out can happen anytime,” he said.

“But still. Once it hits 30%, it’s occurred. Gold is up 50%, you’re locked in at 11%. I don’t like that.”

Mildly bullish on gold

Without necessarily being bearish on stocks, most investors buying gold do so as a form of insurance against market declines, he said.

“The reason you own gold is to protect yourself if we go into a recession, if the stock market has a bad performance. It’s a hedge,” he said.

“Here in order to hedge yourself, you’re hoping that gold goes up a little bit, not up a lot. If it goes up too much, you’re capped.

“You know what? I just buy gold. It’s easier.

“If I’m going to buy a hedge, I want the hedge to be there when I need it.

“This note is capping your hedge. If I’m up 30%, 40%, now I’m capped at 11%.”

Four percent

The appealing part of the note was the 96% principal protection over an 18-month tenor, he conceded.

“It’s nice to know you’re not going to lose more than 4%. But you also know you’re going to lose 4%.”

Examples in the prospectus illustrate the point.

If there is no knock-out, a rise of 20% in the price of gold will translate into a payout of par plus 16%. If the precious metal is up 4%, investors will only receive par back at maturity.

And if a knock-out event occurs, the payout is a fixed return of 11.05% over par, which is equal to $960 plus a $150.50 fixed amount, as it is described in the prospectus.

“Do I really want to pay 4% to have my downside locked in at the risk of underperforming if we go into a recession?” he said.

“You don’t buy gold to have downside protection on gold. You buy gold to hedge.

“If I expect a recession, I’ll just buy the gold fund. It’s much easier that way. I can get in and out of the ETF whenever I want.”

He cited the SPDR Gold Trust exchange-traded fund, which tracks the performance of gold bullion. The fund is listed on the NYSE Arca under the ticker “GLD.”

Market outlook

Carl Kunhardt, wealth adviser at Quest Capital Management, raised a similar point: protecting a hedge is not the most straightforward approach to hedging.

But his main criticism was over the perceived “complexity” of the structure.

“For me, to buy into any investment, I need to see a benefit and an objective. I need to know why I am doing that,” he said.

“If I’m investing in gold, I already have a bearish outlook on the market. I’m going to buy gold if I believe the market is going to go down.

“So this business of having downside protection on gold, which I’m holding to protect myself in the first place, this 96% protection starts to be irrelevant.”

The 4% cost of that protection was also criticized.

“I’m losing 4% right off the bat. Why would I be doing that? I can just buy GLD; I get some exposure and no cap,” he said.

Doubting the hedge

He reasoned that the 96% downside protection becomes “relevant” if the investor is not convinced that the market is going to go down.

“Maybe I’m not that worried. Maybe I’m not sure I really want a hedge if I’m not convinced this market is going to go down,” he said.

“If you’re going to be skeptical, do you not want something to be simple?

“As an adviser, this note is a way to hedge a correction without having a strong conviction that I’m going to need the hedge.

“If I don’t have a strong conviction, why would I want to play games with complexity?”

And there was no doubt that the structure was “complex” in his mind.

“If I show this note to a client, I’m going to see their eyes glaze over.”

Clients need to be able to understand what they’re buying in a couple of minutes, he said. The simpler the structure, the better.

Tough to show

“This is a kind of deal made by a nerdy person in a back office having way too much time on their hands,” he said.

“No real-world adviser is going to spend the time explaining this to a client. It’s way too complicated.

“I work on discretionary accounts with my clients. I’m not asking for their permission. They already gave it to me. But if I’m going to do something that’s not really straightforward, I will sit down and explain to them why I’m choosing this particular strategy.”

Kunhardt said it would be too challenging to explain the product to an investor.

“Once I start explaining it, the client will be like a deer caught in the headlights.”

He added that “sadly” a lot of the complex notes are “sold” to retail investors, not “bought” by them.

“You’re not going to get a financial adviser to do this,” he said.

“Show this to an institutional investor: as soon as you say you lose 4% upfront, they’ll stop you right there and tell you [to] go away.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48130USL0) priced on Oct. 25.

The fee is 1.25%.

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