GS Finance’s capped buffer gears tied to Russell 2000 offer small-cap exposure with less risk

By Emma Trincal

New York, April 18 – GS Finance Corp.’s capped buffer gears due April 30, 2019 linked to the Russell 2000 index allow investors to invest in U.S. small-cap stocks while mitigating risk, advisers said.

The notes are guaranteed by Goldman Sachs Group, Inc.

If the index return is positive, the payout at maturity will be par plus 1.5 times the index gain, subject to a cap of 34.5% to 38.5%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index finishes at or below the initial level but at or above the buffer threshold, 90% of the initial level, the payout will be par.

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

Carl Kunhardt, wealth adviser with Quest Capital Management, said that the notes would be handy for advisers such as him who focus on asset allocation. Instead of reducing the bucket size of an asset class perceived to be risky, an adviser could use the buffered note to reduce the risk while keeping the percentage exposure unchanged.

PC bear talk

“The note is attractive. It goes back to our outlook on small caps. Long-term we’re bullish, but we’re not particularly optimistic for the short or the intermediate term,” said Kunhardt.

This outlook makes a direct investment in the index not very appealing.

Most of the economists he “talks to,” he said, have a “politically correct” way of predicting a market correction in 2016 or 2017.

“They all talk about stocks showing great value right now and how we’re heading toward even better valuations in the near future. It’s a very PC way to say it’s going to go down.

“This is what drove us to a more defensive posture.”

Asset allocators

In order to reduce risk for some asset classes, Kunhardt said that he can either reduce the size of the allocation or buy an instrument that offers a hedge or protection on the downside, he noted.

“If you think that the Russell 2000 is going to correct and be more volatile, then you may want to remove all your small-cap allocation and push everything into blue chips,” he said.

“But by doing that you’re abandoning, even temporarily, asset allocation.”

The notes offer a better alternative in his view.

“You can maintain a modicum of small-cap exposure, and you have a hard buffer. There is still risk involved, but your losses are reduced. You’re mitigating risk.”

Cap

Kunhardt had no objection to the capped upside given his mildly bullish stance.

He assumed a 36.5% cap at midpoint, which with the 1.5 times multiple would yield 10.95% per year on a compounded basis.

Such return would only require the Russell index to rise by 7.55% a year.

“The cap is not an issue for me because I don’t think I’m going to cap out at 11%. And if I did, at that point, I would be happy with that.”

Rebound

Kunhardt said he likes to maintain an allocation for most asset classes, adjusting the size based on his outlook. In some rare cases, however, when the risk is considered to be too high, he cuts his exposure to zero. But he is currently invested in small caps with a 5% allocation.

One of the reasons he keeps his exposure despite a mediocre outlook is because of the upside potential of the benchmark at times.

“Another benefit of this note is to mitigate risk while remaining in small caps because these stocks will lead you out of a market correction. I will have the small-cap exposure to act as the starter for my engine.”

Product

Michael Kalscheur, financial adviser with Castle Wealth Advisors, said he likes the structure of the notes for conservative investors looking to invest in small-cap equity.

From a product standpoint, he said he likes the credit, the underlying and the simplicity of the terms.

“This is guaranteed by Goldman Sachs. While Goldman is not my favorite credit, they’re still OK. Besides, it’s only a three-year. A lower credit quality with a longer term would raise a red flag. But with that issuer on a three-year, we’re completely comfortable,” he said.

The Russell 2000 is a “fine” benchmark, he added.

“It’s the main index for this asset class. It’s very well-known and understood,” he said.

The Russell 2000 also offers more diversification than the S&P MidCap 400 index.

“If you’re looking for broad-based exposure, that’s the way to go.”

Finally, the terms are easy to describe.

“Explanation is key for us. It has leverage, a cap and a buffer. Clients can understand it easily.”

The cost is also acceptable. The fee is 2.75%, or 91.66 basis points per annum, according to the prospectus.

“It’s not great, but it’s still pretty competitive. Anytime we can bring it below 1%, we can look at it.”

Buffer

Kalscheur’ s favorite term of the structure is the 10% buffer.

“Going back 30 years ago, the Russell 2000 has been down 10% or more over a three-month time period only 12.4% of the time,” he said based on historical return data he compiled since 1987.

“When I look at the buffer, knowing that there is only one-eighth of a chance to be down by more than 10% based on my data for this index, I am pretty confident about that type of protection.”

He also looked at the annual dividend yield of 1.5% for this index in order to assess the relative value of the buffer.

A long-only investor would have a 4.5% protection over the three-year term as a result of the dividends.

The 10% buffer offers investors in the buffered note an extra 5.5 percentage points of protection.

“It’s more bang for your buck,” he said.

“The Russell is one of the lowest-yielding indexes I know, and this is relatively short-term compared to a five-year or longer. For three years, you’re only giving up 4.5%.”

In comparison, a three-year note linked to the S&P 500 index or the Euro Stoxx 50 index would cause investors to incur an opportunity cost associated with the dividend loss of 6.3% and 9.5%, respectively.

“I like the buffer because it’s big enough to compensate me for the loss of the yield over that timeframe,” he said.

Mildly bullish, conservative

The upside is also attractive, at least in a modestly bullish scenario.

Looking at the same statistics, he found the Russell 2000 over the last 30 years to be 36.5% up over a three-year timeframe 55.6% of the time.

The 36.5% figure was the hypothetical cap he used to assess the notes.

“It’s a little bit more than half the time. So if the market is very bullish, you might not be doing as good as the benchmark,” he said.

“At the same time, the low yield and high leverage are going to help you break even quickly on the upside.

“If the market is on a tear, I’m not going to be up as much as the market is, but if the market is mediocre, I’m going to be ahead. And by the way, you’re not going to be fired too many times for getting 11% a year for a client.”

Rule of thumb

Kalscheur said that the notes meet his “winning-two-times-out-of-three” rule of thumb.

“If the market is down, I’m going to be ahead with the buffer. If the market is up a little bit, I win with the leverage. It’s only if the market rallies a lot that I won’t do as well. But I win two times out of three.”

The benchmark could significantly rally though given its volatility, he noted, adding that it is probably why the cap is “high” and the terms better.

“I think it fits the bill,” he said.

Kalscheur said he would consider the notes for a conservative investor “nervous about the recent market dips” seen in August and February.

“It’s a nice way to dip your toe into the small-cap arena,” he said.

Goldman Sachs & Co. is the agent.

The notes will price April 26 and settle April 29.

The Cusip number is 36250E613.

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