JPMorgan's $72.43 million notes tied to Efficiente 5 index drew interest due to access, terms

By Emma Trincal

New York, Feb. 29 - JPMorgan Chase & Co.'s $72.43 million of 0% notes linked to the JPMorgan ETF Efficiente 5 index was the largest deal of last week. Investors flocked to the product for its access to a dynamic strategy that offers diversification and low volatility as well as for the full principal protection, sources said.

The notes are linked to an algorithmic index established by JPMorgan in October 2010.

The index dynamically allocates to a basket of 12 exchange-traded funds, tracking their excess return over a cash index, the JPMorgan Cash Index USD 3 Month.

The notional portfolio is rebalanced monthly using the efficiente frontier approach, according to a 424B2 filing with the Securities and Exchange Commission.

On the maturity date, Feb. 29, 2016, investors will receive par plus 110% of any gain in the index, according to the prospectus. The payout will be at least par.

The efficiente frontier approach represents a combination of risk and return with this index using volatility as a measure of risk.

The efficiente frontier approach is derived from the modern portfolio theory approach to asset allocation, which suggests how rational investors should allocate their capital across the available universe of assets to maximize return for a given risk appetite.

Risk mitigation

"It's a great structure and that's why it reached that size," an industry source said.

"People like it for the underlying. ... They get a diversified portfolio of ETFs.

"They also like the asset rotation of the index. You have some rules that tell the index what should get in when the signal is right and what should get out when it's wrong."

The index performance last year was about 11%, according to the prospectus.

"You can reduce risk, and it's fully protected on the downside. From a risk-adjusted standpoint, you get a good return," he said.

The underlying strategy aims to reduce risk by targeting an annualized volatility of 5% or less.

Algorithms and transparency

However, a buysider said that he was not totally comfortable with the proprietary index.

"Using modern portfolio theory to allocate a basket of ETFs is a rational way to allocate assets. However, given the market's recent volatility, it would be prudent to know what the allocation is prior to investing in the portfolio," said Kirk Chisholm, wealth manager and principal at NUA Advisors LLC.

"They do the allocation they want, and they buy what they want. But you, as an investor, you don't decide what you're buying."

The weights assigned to the basket constituents each month are based on the ETFs' performances over the past six months. The index rebalances the weights by picking the ETFs that have exhibited the highest return with an annualized volatility of 5% or less over the past six months, according to the prospectus.

"There seem to be too many unknowns in this issue to feel comfortable with it," the buysider said.

"A piece is missing: How can they price a four-year principal-protection note with a 110% participation rate and no cap on the upside?" he asked.

Cost versus rewards

The strategy itself enabled the issuer to put the structure together, according to the industry source.

"It's based on a volatility targeted index. The index itself has a low volatility, which cheapens the price of the options," he said.

An equity strategist said that the deal "looks good" but that investors should pay attention to the cost.

The fees are 3%, according to the filing.

"The good news is it's an algorithm that does the asset allocation and the rotation for me. I don't have to do the work. So I'm not going to pay for that. The cost is on them," the strategist said.

"In addition, the low volatility target is a nice feature. ... You may want to pay the 3% for that.

"But you do have to make up for this cost. You need a bull market for that type of deal, otherwise your cost may outweigh the upside.

"And the concern is we're not in a trending market. Four years from now, the market may just end up flat. If that's the case, this strategy could prove to be expensive."

Chisholm agreed.

"Modern portfolio theory works well in bull markets but poorly in bear markets," he said.

"In a bull market, diversification reduces risk. In a bear market, most institutionally owned assets become highly correlated, so a diversified portfolio would not necessarily hold up as desired," he said.

So far this year, JPMorgan has priced six notes linked to the JPMorgan ETF Efficiente 5 index with a total principal amount of $78.21 million. Other uses of this index have included certificates of deposit.

The note offering that priced on Feb. 24 was by far the largest in the series this year.

J.P. Morgan Securities LLC was the agent.

The Cusip is 48125VMA5.

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