HSBC's averaging notes linked to S&P 500 Low Volatility may over-emphasize downside protection

By Emma Trincal

New York, Feb. 5 - HSBC USA Inc.'s 0% averaging notes due Feb. 26, 2019 linked to the S&P 500 Low Volatility index may target overly cautious investors. The structure incorporates several features designed to reduce market risk that sources said can be redundant.

The payout at maturity will be par plus the index return, subject to a minimum payout of par. The index's final level will be the average of its closing levels on 24 quarterly observation dates, according to an FWP filing with the Securities and Exchange Commission.

The S&P 500 Low Volatility index measures the performance of the 100 least volatile stocks over the previous year in the S&P 500 index. It is designed to serve as a benchmark for low volatility strategies in the U.S. stock market.

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that the index offered full downside protection to an investment already linked to a more conservative index than the S&P 500, which may have made the protection "overdone."

Double dipping

"The S&P low vol does better when the market is down. You have 31% of the index in utilities, 27% in consumer staples; these are the tried and true baseline essentials of the economy. It has very little exposure to energy, financials, technology and telecom," Kalscheur said.

"This is an index that has outperformed in bear markets. But it underperforms when you have a roaring bull market," he added.

In 2008, the S&P 500 Low Volatility index posted a 23.61% loss versus a 38.49% annualized decline in the S&P 500, according to the prospectus.

However, in 2009, when the market bounced back, the S&P 500 was up 23.45% while the low volatility version of the index gained less, up 15.52%.

"I dislike using the low volatility index inherently in a structured note for a couple of reasons," Kalscheur said.

"Primarily, the reason I buy structured notes is to reduce my potential downside. I am worried about loss of principal.

"The low volatility index already has less risk anyway. It's kind of double dipping. I can do a structured note or I can be long the low volatility index. If I do both together, it's overkill. You're duplicating the product. It's like putting an annuity in an IRA. It's not illegal, but nobody does that."

Giving away too much

The second reason was related to one of the tradeoffs investors have to live with when they buy structured notes.

"With the S&P low volatility index, your dividend yield is higher. Anytime you buy a structured note, you're giving up the dividend yield, and with this particular note, there is more yield to give up than with a typical product tied to the S&P 500," he said.

The S&P 500 dividend yield is 2%. The yield on the S&P Low Volatility index is 2.9%.

"You're giving up almost 1% in dividend. I'm not willing to do that," he said.

Finally, looking at the chart posted on the prospectus, Kalscheur said that he was not convinced that the S&P Low Volatility index offered an attractive return compared to the S&P 500 over a long period of time.

"We had a huge drop in the market in 2008. If you look at the December 2006 to December 2012 six-year period, the S&P 500 Low Volatility index would have underperformed the S&P 500," he said.

"It's hard enough for a client to wrap their brains around buying something off an index; you're basically buying a derivative of the index, and you don't have any idea what the final return is going to be.

"The stock market on average is up two out of three years, but with this you sort of have to guess."

Donald McCoy, financial adviser at Planners Financial Services, agreed.

"It's confusing. You have to prove to somebody there is an inherent value to invest in this index over a long period of time," he said.

McCoy also saw an imbalance between an overly conservative downside and the upside.

"You're already taking care of the downside protection and you're dampening risk another time by using a lower volatile underlying," he said.

"But if you're going to pay for the downside protection, you might want to take on more risk on the upside.

"It looks like the use of this index makes it easier for HSBC to put this out on the market because they can cover their exposure better.

"For investors, this is a way to get equity exposure with principal protection. In a bull market, your investment will do worse than the overall market, and in a down market, you don't care because you're already principal-protected.

"The downside protection for this index doesn't mean much. You're picking up an index less likely to be down over the next six years because it's a less volatile index. It's not a bad index, but you're kind of duplicating the effort."

Quarterly averaging

The soundness of the quarterly averaging payout was also questionable, both advisers said.

According to the prospectus, the return of the notes based on quarterly averaging may be less volatile compared to a return fixed from point to point. In particular, investors may benefit most from the quarterly averaging when the index is up during the term but falls near the end. However, the opposite is also true: the quarterly averaging payout may be less than the point to point when the index declines during most of the term of the notes but increases at the end, the prospectus said.

"What the averaging does is it protects you from falling off a cliff right at the end of the term," said Kalscheur. "There are only a couple of quarters where the averaging could add any value. If you look at the chart, the fall December 2008 period as well as the spring of 2009 were the only times when the low volatility index outperformed the S&P. Otherwise, it underperformed," Kalscheur said.

"So you're really betting on the market to decline in the two or three quarters prior to maturity before cashing in. I think you're rolling the dice. This is why I don't like the averaging aspect."

For McCoy, the averaging payout was another mechanism to mitigate the downside risk added to a structure already highly protected.

"The averaging looks a little bit like a gimmick to me," he said.

"If the market is up over the next six years and if in the last couple of quarters it goes back down, maybe you end up saving some money.

"But the averaging payout also contributes to smooth out volatility, so it's an additional factor that reinforces the idea that the downside protection is a little bit overdone in this product.

"I guess if you're dealing with an ultra-conservative client, maybe. If it was up to me, I'd rather get the S&P 500 with partial protection.

"What they're trying to do is sell it as a relatively safe investment: we're going to give you a low volatility index, we're going to average the quarterly returns, and we're going to throw in the full downside protection. If you're really selling to nervous clients, you have those three points to make. But whether it makes sense or not, I am not sure."

Non tactical

Kalscheur added that the long tenor was also a drawback, especially with this type of index.

"If you're going to play with beta, if you want more volatility or less volatility, you have to be tactical, you have to be liquid. If you're locked in for six years, by definition you can't be liquid or tactical, which I think defeats the whole purpose," he said.

He suggested a strategy that would alternate the exposure to the S&P 500 Low Volatility index and to the S&P 500 High Beta index depending on whether the market was falling or rising.

The S&P 500 High Beta is the inverse version of the S&P 500 Low Volatility index. It tracks the 100 most volatile constituents of the S&P 500 index.

"We don't do trading games. But I suppose a Goldman Sachs could reallocate monthly or quarterly the exposure to either the high beta or low volatility version of the S&P 500 depending on the direction of the market at that time. It makes little sense to stay invested in one of those two indexes for six years. You know that the low volatility index is not going to do well in a bull market and that the high beta version will underperform in a bear market. Being locked in for six years to the same index hinders your ability to benefit from it.

"If some issuer could put together a note tied to a black box index with a rule that would say if the low volatility outperforms the S&P by X percent this quarter, switch to this index ... if the high beta is the one that outperforms, switch to that one, and do this for six years, I'd be very interested," he said.

HSBC Securities (USA) Inc. is the agent.

The notes will price Feb. 21 and settle Feb. 26.

The Cusip number is 40432XAC5.

© 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.