HSBC’s allocation securities tied to basket of three ETFs to aid advisers’ allocation process

By Emma Trincal

New York, Oct. 11 – HSBC USA Inc.’s 0% allocation securities due Oct. 29, 2021 linked to a basket of the SPDR S&P 500 exchange-traded fund, the iShares MSCI EAFE exchange-traded fund and the iShares MSCI Emerging Markets exchange-traded fund offer investors and advisers a tool to optimize asset allocation by assigning different weightings to the underlying ETFs based on their performance at maturity, according to an FWP filing with the Securities and Exchange Commission.

The best performing of the ETFs will be given a 60% weight, the ETF with the second-best performance will be weighted at 40%, and the lowest-performing ETF will not count toward the basket performance.

The payout at maturity will be par of $10 plus the basket return. The notes are not principal protected, so investors will receive less than par if that basket return is negative.

Unusual

“This is unique. I haven’t seen that before,” said Tom Balcom, founder of 1650 Wealth Management.

“One of the things advisers grapple with all the time is how to make the right asset allocation decision. Nobody knows really which asset class will outperform five years from now. This note does it for you,” he said.

The structure offers no leverage, no cap and no downside protection. Its entire value lies in the flexible weightings allocated at the end of the term, which favor the best-performing ETF while reducing and eliminating the others by decreasing order of return.

“It’s very appealing that they eliminate any exposure to the worst one,” he said.

The structure is not common. HSBC appears to be the only issuer bringing such product to market, according to data compiled by Prospect News.

This year, the only similar deal to price came out in August. HSBC priced $4.5 million of notes linked to a basket comprising the Euro Stoxx 50 index, the Russell 2000 index and the S&P 500 index. The weights were 40%, 35% and 25% for the highest return, the next-to-highest return and the lowest return, respectively. The agent was Morgan Stanley. Last year, HSBC priced four similarly structured offerings for a total of over $7 million.

“I’d be curious to know how they constructed it,” he said.

“It’s definitely an interesting concept.”

Performance

Instead of having to rebalance the portfolio, advisers could take advantage of the notes doing it for them at maturity.

Some asset classes such as emerging markets have underperformed in the past five years, he noted. The iShares MSCI Emerging Markets ETF has only gained 2.15% over the past five years while the SPDR S&P 500 fund has jumped 84%. The iShares MSCI EAFE ETF has gained 18.2% during that time.

“It looks like the S&P 500, which has solidly outperformed, may not be in the same place in five years. Meanwhile, the emerging markets could outperform. But the reality is no one knows for sure. This note is a tool to remove the uncertainty from the equation,” he said.

“At first glance, I like it. It gives you peace of mind when making your allocation. I think it would make sense for many advisers.

“You can use it as a rebalancing tool. If you make money at the end, you can use the proceeds and go to areas that have underperformed.

“The trade-off of course is that you don’t get the total return. You only get the price return.”

Dividends

As with a majority of structured notes, investors have to forego dividends. This disadvantage increases when the maturity is longer as more unpaid dividend returns accumulate.

“It’s hard to tell in advance how much this compelling automatic allocation can offset the loss of dividends. ... It would depend on whether most of the returns come from dividends. It would vary depending on the market, so that’s something you can’t really predict,” he said.

But assuming a 2.5% dividend on average for the three ETFs – the S&P 500 fund and the emerging markets ETF each have a 2% dividend yield, and the EAFE fund has a yield of 2.85% – investors would have to give up about 12.5% in returns due to the non-payment of dividends.

“It doesn’t mean you don’t end up ahead, especially given that you don’t have any allocation to the worst index. But it’s something to take into consideration,” he said.

Balcom said that the note still “sounded appealing” but that “I wouldn’t mind having a little bit of leverage to compensate for the dividends.”

Rich S&P

Steven Jon Kaplan, founder of TrueContrarian Investments, expressed concerns over the duration of the notes and current market levels.

“It’s unusual. It’s certainly interesting to have an allocation based on best returns, but it doesn’t mean there is not a fair amount of risk involved,” Kaplan said.

“The biggest risk is the high valuation of the U.S. equity market right now. The S&P 500 is at such unusually high levels that during the next five years we’re likely to have a big drop, maybe a couple of years from now. Even if we recover – and we will at some point – we probably won’t go back up to where we are right now.”

Kaplan found little comfort in the fact that the worst-performing fund would not count toward the final basket performance as he expects a bear market to hit worldwide.

“It’s possible that emerging markets would do better but short term only. They may have a good year ahead simply because they had so many losses this year. But if we have a worldwide recession, emerging markets tend to lose more than the U.S. It could be rough in a number of different markets. I would not want to be holding any of those securities for so long.”

Bearish take

For Kaplan markets are heading toward a new cycle marked by falling stock prices and rising inflation.

“The Fed has kept interest rates very low for a very long time, fueling this huge asset bubble. I think we’re approaching the end of this. The world is moving away from quantitative easing. We’re moving from asset prices inflation to real inflation, and it’s going to hurt,” he said.

Kaplan looks for asset classes that are undervalued and have become unpopular.

“Buying the S&P 500 today at those levels makes no sense to me. At 2,100, we are still more than three times where we were during the last bottom,” he said. He referred to the bottom of the previous bear market in March 2009 when the S&P 500 index was just below 700. The S&P 500 closed at 2,136.73 on Tuesday.

If the benchmark were to fall back to its 700 low within the next five years, its price would have to triple in order to recapture today’s price level, he observed.

“And you wouldn’t be making any money,” he said.

“I would much rather make my own allocation decisions and go for value, focusing on what has fallen out of favor with the flexibility to change as we move forward.”

The notes will price Oct. 26.

UBS Financial Services Inc. and HSBC Securities (USA) Inc. are the agents.

The Cusip number is 40435B551.

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