GS Finance’s two deals linked to iShares EAFE, EM ETFs offer interesting choice, advisers say

By Emma Trincal

New York, Aug. 7 – GS Finance Corp. will price two nearly identical deals with differences that represent a trade-off between more leverage on the upside and excess return on the downside.

Two advisers reached the same conclusion in choosing their preferred deal: getting alpha from a market correction is more attractive than additional leverage.

GS Finance plans to price two offerings. The notes in both cases carry the following identical terms:

• The maturity date is Feb. 11, 2021;

• The underliers are the iShares MSCI EAFE exchange-traded fund and the iShares MSCI Emerging Markets exchange-traded fund;

• The barrier is 70% of the initial share price of the lesser-performing ETF, observed point-to-point; and

• If either ETF drops more than 30%, investors lose 1% for each 1% decline of the lesser-performing ETF from its initial share price.

Leverage versus absolute gains

Now for the differences.

The first issue offers 2.3 times leverage, but the barrier adds nothing more than the usual contingent protection.

The second deal on the other hand has less leverage at 1.65 times, but if the lesser-performing ETF is negative without falling more than 30%, investors get the absolute value of the decline, according to two separate 424B2 filings with the Securities and Exchange Commission.

Subdued returns

Carl Kunhardt, wealth adviser at Quest Capital Management, said he likes “neither one of them,” because worst-of payouts “take more than five minutes to explain to a client,” and as a result, “the conversation almost always goes nowhere.”

But for the sake of comparing the two products, he said that he likes the note with the absolute return.

“None of them are capped. It doesn’t really mean anything. The cap is moot because we don’t expect high returns over the next three to five years,” he said.

He sees only 5% a year in U.S. equity markets over the next decade.

Playing defense

With returns limited on the upside, it becomes important to consider the downside, especially eight years into a bull market, he noted.

“Valuations are stretched. The downside becomes as important as the potential upside,” he said.

“Am I willing to give up some of the leverage, take 1.65 versus 2.3, and take the absolute return on the downside as opposed to par? Yes. Yes because par is a loss. ... It’s not an absolute loss, but it’s a loss in opportunity.

“The possibility of getting something trumps the additional leverage.

“The issue of being able to translate a potential loss into some positive return I think is more beneficial to me than not.”

Useful exercise

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said the comparison is interesting because the notes are so similar.

“Everything is almost the same. It’s the leverage versus the absolute return. You’re isolating these two factors, which for most of us is kind of an intriguing thing ... when you can actually price out the difference,” he said.

“It gives you an interesting choice to make.”

Kalscheur acknowledged first that the difference in the leverage multiples will make “a lot of” difference, especially over three and a half years.

However, the benefit of the absolute return is notable, especially the farther the underlying goes down.

“You have to ask yourself, what are the actual chances of hitting the absolute return?” he said.

A look at EAFE

Kalscheur uses backtesting and probabilities to make his decisions in regard to risk and expected return each time he considers buying a structured note.

With benchmarks such as the S&P 500 and the Euro Stoxx 50, he said he has decades of data for any rolling period.

Unfortunately, his statistics for the iShares MSCI EAFE ETF begin in 2001 and therefore show only a short track record. He has no relevant data on the iShares MSCI Emerging Markets ETF, he added.

“I know that emerging markets are much more volatile. Other than that, the data I have on this fund is not very helpful,” he said.

Robust barrier

Settling for the incomplete but available data he has at his disposal for the EAFE fund, Kalscheur examined the downside scenarios.

Looking at any three-and-a-half-year rolling period over the past 16 years, he found that the odds of a loss in excess of 30% were negligible at 0.8%.

“This tells me that the barrier has a strong probability of doing its job. I know I’m using the EAFE as a substitute and that I don’t have the emerging markets, but it still gives me some confidence that the barrier is viable,” he said.

Nearly one-third chance

Kalscheur then proceeded to look at the absolute return scenario, the one in which the EAFE fund during the same period would finish negative without breaching the 30% barrier.

“This is the most telling. I have a 31% chance to fall into the absolute return scenario,” he said.

He broke down the probabilities in smaller increments. While there is a less than 1% chance of breaching the barrier, the probability of a return between zero and negative 10% is 7.3%, the probability of a return between negative 10% and negative 20% is 13.6%, and there is a 9.5% probability of a return between negative 20% and negative 30%.

“Having a 31% chance ... almost a third ... of benefiting from the absolute return is not slim,” he said.

He said that if applied to the S&P 500, the same calculations would reveal a 14% probability of the index finishing down by less than 30%.

“If that note was on the S&P, I probably would say no to the absolute return,” he said.

“But if you have a 31% chance to get a positive return out of a negative return, I would want to profit from that, especially when the market is at all-time highs.

“Besides, you’re not giving up all the upside. You still have 1.65 times leverage. It’s actually pretty good.”

Rational choice

Kalscheur said he would have to do more research since he is missing the data for the emerging markets ETF, which also shows a greater level of volatility with a standard deviation of 23.8 versus 18.57 for the EAFE index.

“If I had better data, I would be more confident to say that I would take the absolute return note,” he said.

“It’s actually interesting because taking less leverage is counterintuitive for me. My guts would tell me to go for more leverage. I am an optimist, and I’m usually in the market to get all of the upside I can get.

“But if there really is such a high probability of profiting from the absolute return, it’s very attractive. The absolute return has a great deal of value, especially if you’re doing a worst-of, so I think it would be my choice.”

For both issues, the guarantor will be Goldman Sachs Group, Inc., and Goldman Sachs & Co. will be the agent.

Both offerings will price on Tuesday and settle Friday.

The Cusip number is 40054LNQ3 for the issue with more leverage and 40054LP65 for the notes with the absolute return.

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