GS Finance’s autocalls on BlackRock Dynamic Factor index offer multi-asset exposure, low vol.

By Emma Trincal

New York, April 18 – GS Finance Corp.’s 0% autocallable index-linked notes due May 10, 2029 tied to the BlackRock Dynamic Factor index provide an annualized call premium based on the exposure to a diversified multi-asset index targeting a 5% volatility. While the terms of the notes are “relatively attractive,” especially the principal-protection, the “complexity” of the underlying index may give investors pause, said Clemens Kownatzki, finance professor at Pepperdine University.

The notes will be called at par plus an 8% annual call premium if the index closes at or above its call level on any annual call observation date. Call levels begin at 102.5% of the initial level and step up by 2.5% per year, according to a 424B2 filing with the Securities and Exchange Commission.

If the notes are not called, the payout at maturity will be par plus the index return if the index finishes at or above its initial level.

Otherwise, investors will receive par.

Good structure

“The structure is relatively attractive. You get the principal protection and a call premium of 8%,” said Kownatzki.

“The premium could have been higher. I suppose a lot goes into the principal protection.

“Another aspect of the cost structure is the layer of fees they have to pay getting in and out of the underlying ETFs. “Those are probably not huge fees. But it adds up.”

If the structure, including the call strike stepping up by 2.5% increments, was pretty straightforward, the underlying algorithm required closer attention.

“It's a very complex derivative. The product invests in individual ETFs, each ETF being itself a stand-alone portfolio,” he said.

Dynamic portfolio

The index allocates to a portfolio of weighted ETFs and a cash constituent, according to the prospectus. It combines an equity ETF basket consisting of up to five equity ETFs, a fixed income ETF basket composed of up to three fixed income ETFs and a cash constituent.

The weights of the ETFs within the equity basket are determined based on three factors – “economic regime,” “value” and “momentum,” while the weights of the ETFs within the fixed income basket are determined based on “how medium-term interest rates are trending,” the prospectus said. The algorithm seeks to limit realized volatility to 5% each day.

The index tracks the return of the weighted ETFs and any cash constituent above the sum of the return on the interest rate (SOFR plus 0.26161%) and the index fee (0.65% p.a. accruing daily).

Disappointing factors

“The factors they’re using, momentum, value and low volatility, have been around for a long time,” said Kownatzki.

One key piece of the index was its low-volatility strategy, he noted.

“I’m just wondering why going through this complex strategy. There are many ways, and simpler ways, to achieve low volatility in a diversified portfolio,” he said.

He noted that the equity components of the BlackRock Dynamic Factor index have declined in price this year.

The iShares MSCI USA Momentum Factor ETF for instance is down 13% year to date while the iShares MSCI USA Value Factor ETF lost 7%. The iShares MSCI USA Size Factor ETF dropped 6.7% and the iShares MSCI USA Min Vol Factor ETF fell by 3.7%.

Cash overload

“Those returns, which are packaged in a low volatility strategy, are far from impressive,” he said.

At the same time, controlling volatility makes sense in the current environment, he noted.

“Volatility is higher than it has been in the past five or six years. We haven't had any severe recession or stock market crash. Given everything that's happening in the world, there is a strong argument to be made for a vol. control index,” he said.

But Kownatzki pointed to some drawbacks.

“I have a problem being 100% cash. You can have a very sizable cash component,” he said.

Each asset class has a maximum weight – 60% for equities, 50% for fixed-income and 100% for cash.

The prospectus warned that investors may have a limited market exposure and a significant allocation to the cash constituent just as a result of the controlled volatility. As an example, the filing noted that cash “in the recent past” represented as much as 85.5% of the index.

Transparency was also a concern.

“It’s not totally clear to me how the algorithm rebalances the portfolio. We know that the 5% volatility target determines the allocations but what are the other factors and what are the rules followed by the algorithm?” he said.

“Clearly, it’s a complex product. I can imagine that it would be challenging for an adviser to explain it to a client because there is a black box element to this index.”

Parking meter

One obvious advantage of the note was the full principal-protection.

“With the low volatility you run the risk of a very low return of course, which would not be ideal after holding the notes for seven years, especially if inflation remains high for some time,” he said.

“On the other hand, some investors are OK with principal protection and perhaps losing some upside as long as they can sleep at night.”

The value of “safety” varies from one individual to another, he said.

He offered a personal example.

“At some point, I was investing in Swiss bonds which have a negative yield. But the currency is strong and holds its value. I was parking my money in a safe place. That negative yield, I compare it to a parking fee. You get a relatively low return, but your volatility is under control,” he said.

The issue of potentially low returns was “part of the territory” when one invests in a low-volatility index.

“People who seek low volatility assets need to understand that they are not going to get massive returns,” he said.

Secret sauce

Kownatzki’s main criticism centered on the underlying portfolio.

“It’s difficult to invest in an index when you don’t exactly know how it’s going to operate. It’s a little bit like a discretionary mutual fund or a hedge fund. They proceed to placing trades and making allocations without a lot of explaining. You’re supposed to trust them. As long as the returns are good, nobody questions their approach. Maybe they’ve found the Holy Grail! I can understand why they would not want to be too explicit about their strategy. If they were, whatever hedges they would have would be gone,” he said.

Kownatzki’s conclusion was mixed.

“I like the cumulative nature of the call premium. I like the principal protection.

“But I’m sitting on a fence.

“The index strikes me as very complicated. You really have to understand what’s inside the black box. That would be my biggest hesitation.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The notes will price on April 26 and settle on April 29.

The Cusip number is 40057LQC8.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.