JPMorgan’s buffered return enhanced notes on EM ETF aimed at moderate bulls only

By Emma Trincal

New York, May 19 – JPMorgan Chase Financial Co. LLC’s 0% capped buffered return enhanced notes due June 3, 2022 linked to the iShares MSCI Emerging Markets ETF offer a straightforward leveraged buffered structure, but the cap raises concerns, advisers said.

The ability of investors to tolerate the modest upside potential will depend on how bullish they are on the asset class.

The payout at maturity will be par plus 2 times any ETF gain, up to a maximum payout of par plus 16% to 20%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the ETF falls by up to 10% and will lose 1% for every 1% decline beyond 10%.

Michael Kalscheur, financial adviser at Castle Wealth Advisors, at first was not impressed by the cap and the underlying asset. But looking at the structure more closely, he found that it had a place in a conservative portfolio.

U.S. bias

“I have to disclose that I’m a little bit biased toward the U.S. Why do U.S. indexes trounce all other markets? It’s because of our technology. Apple is an American company, Microsoft is an American company, and so are Amazon, Facebook, Google or even Netflix.

“We’ll continue to outperform other markets as long as we continue to dominate in the technology arena,” he said.

While every adviser needs to diversify across different asset classes, Kalscheur would not overweigh international equity.

“I’m not crazy about emerging markets, especially for conservative and older investors. Volatility is higher, returns are lower. I would not allocate more than 20% of my total equity exposure to international stocks. Some target funds do more than that. But I wouldn’t,” he said.

A few good things

Kalscheur pointed to some of the positive aspects of the deal.

“The leverage and the downside protection are good,” he said.

“It’s a two-year note. We’re fine with that.

“As an issuer, JPMorgan is a class act there...No issue at all.

“The 75-basis points fee is competitive.

“And it’s got a 10% hard buffer.”

Protection

The buffer was an important element of the structure. Kalscheur assessed it based on historical data he has collected on the underlying fund since its inception in 2003.

Looking at two-year rolling periods going back to that time, he found that the ETF finished negative 39% of the time.

“I don’t want to put hard and fast rules on less than 20 years’ worth of data, but I can see a risk of over 30% to lose money in that index during a two-year period.

“This tells you how valuable the buffer is.

“I like that.”

Low cap

The not-so good part was the cap on the upside.

“It’s not as high as I would like a cap to be especially for a volatile index like this one,” he said.

The 16% to 20% range over the term is the equivalent of 7.70% to 9.55% return on an annualized compounded basis.

“This cap is just not high enough. This is what I run into when I look at capped notes.”

Using the same historical data, Kalscheur examined the “upside” risk: he found that the underlying historically finished at more than 20% 38% of the time.

“You just can’t be a roaring bull, that’s for sure. The chances of capping out are fairly high,” he said.

And yet, Kalscheur found some value in the structure based on his back-testing analysis.

Two out of three

“If I am consistent with the rule of thumb I give people when I review structured notes, this actually fits the bill,” he said.

His rule, he said, is quite simple: “you need to win two out of three times.”

In this case, the formula may work, he explained, showing three different scenarios.

“If the index is negative, I win thanks to the buffer.

“If the return is positive but only slightly up, I win too. I can outperform the ETF with the leverage.

“If the index is up a lot, I’m capped out. I lose.

“I win two out of three times.”

Kalscheur said this type of note could not replace an active manager, which is how he typically gets exposure to emerging markets. But it may be used as a complement or a hedge.

“When I looked at it the first time, there were several things that red-flagged me. But come to think of it, if you use it as a defensive play, as a complement to an active manager for a portion of that emerging markets allocation, it works. Just don’t offer it to a bull.”

Bullish

Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, was precisely bullish on emerging markets. To him, the cap was a “dealbreaker.”

“JPMorgan is one of the strongest credits in the U.S. It’s not about the issuer. I just don’t like the terms,” he said.

“I don’t really want to be capped on an asset class that had a significant decline,” he added.

The ETF dropped more than 19% so far this year compared to less than 10% for the S&P 500 index.

“Emerging markets have been down for a while. If there is any reversion to the mean, you’re looking at much more than 8% a year.

“We know emerging markets are due for a nice increase because valuations are very modest. It’s a cheap asset class,” he said.

Another reason not to tolerate the cap was the opportunity cost associated with the non-payment of dividends.

“You’re giving up more than 3% in dividend.

“And you’re capping out at 8%. It makes no sense.”

The ETF has a 12-month trailing yield of 3.35%.

For Foldes, the 10% buffer was “totally unnecessary.”

“In two years, we will have the benefits of medical intervention against Covid-19. The world will already have a vaccine and/or a cure. The price of emerging markets stocks should be reflective of that,” he said.

Long only

Foldes would eliminate the 10% buffer to increase the cap. But even a reshuffled version of the note may not satisfy this adviser’s bullish view. The short-dated tenor would make it difficult to reprice in a better way.

“I wouldn’t want to go longer. Even if you get rid of the buffer, it wouldn’t boost the cap to where it needs to be,” he said.

In good years, the volatile ETF can show exceptionally high gains, such as its 36% positive performance in 2017 for instance.

“If emerging markets begin to rally again, it would be within the realm of possibilities that this ETF could be up 50% in two years.

“So many things could be happening when this Covid-19 crisis is over.

“This is one of those underlying where it doesn’t pay to use a structured note. I would prefer to buy the ETF directly and capture the full upside,” he said.

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price on May 29.

The Cusip number is 48132KQ65.

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