HSBC’s barrier leveraged notes linked to low volatility ETF aim at curbing risk in correction

By Emma Trincal

New York, Oct. 23 – HSBC USA Inc.’s 0% barrier leveraged tracker notes due October 2016 linked to the PowerShares S&P 500 Low Volatility Portfolio exchange-traded fund target investors looking to keep their exposure to the equity markets while curbing volatility risk in the event of a correction, sources said.

If the ETF return is greater than zero, the payout at maturity will be par plus at least 115% of the ETF return. The exact upside participation rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the ETF falls by 10% or less and will be fully exposed to the ETF’s decline from its initial level if it falls by more than 10%.

The ETF replicates the return of the S&P 500 Low Volatility index, which measures the performance of the 100 least-volatile stocks in the S&P 500 over the past year.

HSBC brings to market similar notes several times a year. Its last one priced at the end of September for $757,000, according to data compiled by Prospect News.

The S&P 500 Low Volatility index helps reduce volatility risk for investors who believe a market correction is coming, sources said. Historically, it has outperformed the benchmark in down or choppy markets, according to S&P Dow Jones Indices’ website.

Staying in equities

“These strategies are becoming increasingly popular, and I do expect to see some more,” said Vinit Srivastava, senior director, strategy indices at S&P Dow Jones Indices.

“We’ve had that bull run. Investors have done well. But now, there is some unease. People don’t know where we’re heading to. Last week, we’ve seen volatility, and people didn’t want to get out of equity because they’re not sure fixed income is an alternative. They want to remain invested in stocks, but they lack confidence. That’s why we see more interest in these low-volatility strategies.

“Low-volatility strategies tend to underperform the benchmark in a bull market and outperform in a downturn. It’s generally true historically because these low-volatility stocks have a lower beta than the S&P. So if the market is taking off, they will underperform. But when it’s flat or bearish, it’s the other way around.”

Bear proof

In 2008, the S&P 500 Total Return index lost 37%, according to S&P Dow Jones Indices. In comparison, the S&P 500 Low Volatility Total Return index outperformed significantly with a 21.4% loss. In 2011, the benchmark generated 2.1% while the low-volatility index posted a 14.8% gain. “It was a choppy year. Low volatility did well,” Srivastava said.

On the other hand, during last year’s strong rally, the S&P 500 Low Volatility Total Return index generated a 23.6% positive return, underperforming the 32.4% performance of the benchmark.

This “asymmetry” can disappear over the long haul, noted Srivastava.

“Over a long period of time, low volatility can outperform in all markets,” he said.

“Academic research shows that over a long period of time, less-volatile stocks tend to do better than the benchmark,” he said.

“This is because over a 15- or 20-year period, they outperform better on the downside than they underperform on the upside. A lot of papers have been written on this anomaly. Of course, over a short period of time, it’s a different story. But historically, it’s been shown that participation in the downside has been lower than participation in the upside.”

Alternative to the S&P

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he likes the strategy.

“It’s a diversified and less-risky way to buy U.S. large caps,” he said.

“A lot of investors have concerns over the market and the run-up we had over the last few years.

“Because of the widespread geopolitical risk, the S&P 500 continues to be the safe haven.

“This particular note is different in a sense in that you are looking at the lower-volatility type of stocks, which is of interest to a lot of investors today.”

Looking at the structure, Medeiros said the 90% barrier is a positive.

“The downside protection is nice in the portfolio, especially point-to-point. Ten percent is enough for this type of underlying,” he said.

“If we see some correction, these low-volatility stocks are likely to hold better than other large caps, such as tech stocks, for instance.”

Information technology has a weighting of only 5.73% in the S&P 500 Low Volatility index. The top three weightings are financials (23.63%), utilities (20.28%) and consumer staples (15.84%).

The small leverage factor of 1.15, he said, is not a concern.

“I’m not a huge fan of leverage ... anyway. People look at this type of product for the stability of the returns. This is a conservative note, not an aggressive one,” he said.

“The concern is if the S&P 500 continues to rally. In this type of market, there is an equal upside risk as there is a downside risk.

“That said, maintaining a diversified large-cap portfolio among the less-volatile components of the S&P is a prudent way to keep your exposure to the market.

“It’s not a super value play. Both the S&P and the Low Volatility S&P index are trading at the same P/E ratios. But it’s another way to buy some of the larger caps, which at this point in the market is a very interesting opportunity.”

Safe haven

Medeiros said that he views the S&P 500 as relatively low risk compared to other international benchmarks or asset classes.

“If we see a global correction, you can expect a high correlation on the downside between asset classes and various parts of the world,” he noted.

“But at this point in the market cycle and given the geopolitical risks we are exposed to, the S&P and mid-term Treasuries are essentially the new safe havens.

“I just mean that if you’re concerned about Europe and want to minimize your exposure, you’re not going to take your exposure to Brazil.

“Until we know what happens in the world, the S&P is a better way to diversify the portfolio without taking other risks.”

Bunch of statistics

Marc Gerstein, research consultant at Portfolio 123, said he is skeptical about low-volatility strategies. The structure of the notes, however, offers some benefits.

“It’s not bad. There are worst things to do because the market shows some weakness,” he said.

“You have two forms of protection: the low-volatility underlying and the 10% [barrier] in the structure. I don’t object to the strategy, but I don’t trust volatility statistics as much as people do. You’re looking at what the stock has done in the past; you’re not going forward.”

He pointed to financial stocks.

“Before 2008, financials were considered low volatility,” he said.

“A low-vol stock can become a high-volatility stock fast, and your index will be lagging ,” he said.

“With quarterly reporting, earnings every three months, you can get things happening very quickly, so having a 10% cushion on the downside is a good thing.”

In defense of the index, Srivastava said, “We rebalance every quarter. Financials started to become volatile in late 2007. We updated the index then. By the time the crisis hit in 2008, the index had already eliminated the sector. We just get the less-volatile stocks in the index. We’re not saying it’s better or worse. This is not about performance. It’s about volatility.”

The real world

Gerstein said the barrier is an attractive aspect of the notes.

“The 1.15% leverage is not bad. There’s no cap. I don’t have a problem with the structure,” he said.

“I’m just a little skeptical about the low-volatility strategy. I think those indexes are done by mathematicians who may have no clue about the market and businesses.”

He gave some examples from the list of the top 10 holdings in the index, including United Parcel Service Inc., Wal-Mart Stores Inc., Procter & Gamble Co., Chubb Corp., Travelers Cos. Inc. and Berkshire Hathaway Inc.

“Proctor & Gamble ... They’ll probably be OK. But take UPS for instance. UPS is not low vol. In a recession, it’s getting killed. I don’t care what the statistics show. If you have a slowdown, you won’t have deliveries. Wal-Mart may muddle along. But insurance stocks like Chubb, I have no idea. I don’t know what’s in their portfolio and what they’re underwriting. Insurance is not likely to be less volatile. I could say the same about Travelers and even Berkshire Hathaway. I used to trust insurances, but we don’t know what’s going on under the surface,” he said.

“My point is that the low-volatility strategy may be OK if we have a little correction. But if it’s more serious, I think the extra 10% cushion is likely to help.”

HSBC Securities (USA) Inc. is the underwriter.

The notes will price and settle in October.

The Cusip number is 40433BRN0.

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