GS Finance’s $1.55 million leveraged notes on EM suitable for a small allocation, advisers say

By Emma Trincal

New York, Aug. 1 – GS Finance Corp.’s $1.55 million of 0% leveraged buffered ETF-linked notes due July 29, 2025 tied to the iShares MSCI Emerging Markets ETF are not exempt from risk despite the buffer, making the note suitable only as a small portion of the overall portfolio, advisers said.

If the ETF return is positive, investors will receive par plus two times the ETF gain, capped at par plus 31%, according to a 424B2 filing with the Securities and Exchange Commission.

If the ETF return is flat or falls by up to 10%, the payout will be par.

Otherwise, investors will lose 1% for every 1% decline beyond 10%.

Diversification

“I haven’t seen a lot of emerging market deals lately,” said Tom Balcom, founder of 1650 Wealth Management.

Diversification away from domestic stocks, however, will always be a must for asset allocators.

“You should always have a diversified portfolio and that includes international markets,” he said.

Balcom said he allocates 20% of his portfolio to international equities, which includes 5% to emerging markets.

“We don’t over-allocate to emerging markets because it’s a volatile asset class,” he said.

“That’s why having a buffer in a note is always a positive.”

Risk-adjusted return

The implied volatility of the iShares MSCI Emerging Markets ETF is 24.74% compared to 14% for the S&P 500 index.

A relatively short-dated note linked to a volatile underlier would benefit from more downside protection, Balcom said. But investors should always consider the risk-adjusted return of a note.

“It’s a two-year. 10% is a modest buffer. But I always look at what you will be using the note for. Compared to a long-only position in the ETF, you’re better off with the buffer even if it’s only 10%. If the index is down 20%, you only lose 10%. Also, there is no gearing on the downside. That’s also a plus.”

The maximum return was reasonable, according to this adviser. On a compounded basis, investors in the notes may earn up to 14.5% on an annualized compounded basis.

“That’s not too shabby for a cap, and the note provides a degree of protection.”

Cap

On the upside, investors in any capped note always run the risk of underperforming the underlying.

The iShares MSCI Emerging Markets ETF has seen exceptionally strong years, when an annualized return would exceed the 31% cap on the two-year notes. For instance, in 2017, the ETF gained 36.42%.

On the other hand, the ETF can also easily drop more than the buffer amount. Last year, it posted a 20.55% loss.

“If the ETF goes to the moon, you’ll be capped out at less than 15% a year. But if you’re bullish on emerging markets, don’t use a note. You buy the ETF,” he said.

Balcom said his emerging markets bucket is entirely made of structured notes, not direct investments in the ETF.

“I use notes so I can mitigate the risk,” he said.

Concentration risks

The iShares MSCI Emerging Markets ETF presents some characteristics that increase the risk, which relate to high levels of concentration in the portfolio as illustrated by countries, sectors and holdings breakdowns, he noted.

China makes for 30.48% of the fund and the two top sectors (financials and technology) make for almost 42% of the total. In terms of holdings, the top three names (Samsung Electronics Ltd., Taiwan Semiconductor Manufacturing and Tencent Holdings Ltd. have a combined weighting of 14% out of 1,242 names.

“You almost have a third in China, and that’s a risk. That’s why we only have 5% in emerging markets, and we diversify it across different notes. With 30% of the ETF in Chinese stocks, we only have a 1.5% exposure to this country through this fund. That’s only a small piece of the puzzle,” he said.

Small amount

A financial adviser noted that the notes required a very specific investor’s profile given the capped upside and limited downside protection.

“It’s a pretty straightforward, plain-vanilla note,” this adviser said.

“The only spicy thing here is the index. It can move in either direction, easily exceeding the buffer or the cap.

“If you invest in emerging markets, you’re taking a lot of risk anyway. I don’t know how appropriate it would be for conservative clients to use this unless you’re putting a small amount of it in the portfolio.”

Modest expectations

The note may meet the needs of more aggressive investors but under certain conditions, he added.

“It should be for an aggressive investor seeking exposure to the index but with a specific view. They can’t expect too much of a return over the next two years,” he said.

In conclusion, given the volatility of the asset class and the limitations of the structure, advisers may not easily find takers.

“This note would have a rather limited appeal. You have to be willing to give up the upside for a little bit of downside protection. Emerging markets can pop much more than the cap, and for this ETF, 10% on the downside is really not a lot.

“However, if you don’t think much is coming down the pike, this would be the way to go,” he said.

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The notes settled on July 27.

The Cusip number is 40057TMR2.

The fee is 0.5%.

© 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.