Bank of Montreal's notes tied to iShares Russell offer small cap exposure, appealing terms

By Emma Trincal

New York, Nov. 5 - Bank of Montreal's 0% buffered bullish enhanced return notes due Nov. 30, 2015 linked to the iShares Russell 2000 index fund are designed for investors willing to invest in a three-year product and looking for small-cap exposure, sources said.

The structure was seen as attractive if one liked the tenor and the underlying.

The payout at maturity will be par plus 300% of any gain in the fund, up to a maximum payout of $1,292.50 to $1,322.50 for each $1,000 principal amount, according to a 424B2 filing with the Securities and Exchange Commission. The exact cap will be set at pricing.

Investors will receive par if the fund falls by up to 15% and will lose 1% for each 1% decline beyond 15%.

Three-year term

While some financial advisers never buy products longer than two years, for Michael Kalscheur, financial adviser at Castle Wealth Advisors, the three-year tenor was suitable.

"It looks pretty clean. The structure is pretty straight. Three-year is not an issue for us. We don't even consider that long term. Since principal protection is our number one priority, we're happy to give up liquidity for protection. And this one has a decent 15% buffer," he said.

Sometimes longer-dated notes add peace of mind to an investment, he added.

"If the 15% buffer was on a 13-month product, it would bother more than on a three-year," he said.

"We don't think three-year is too long. A three-year standard deviation on the Russell is going to be lower than a one-year standard deviation because the up-years and down-years tend to balance each other out.

Small caps

Kalscheur said that there was nothing wrong with the underlying exchange-traded fund, except for the fact that only a few of his clients are actively investing in the small cap segment of the U.S. equity market. By contrast, most of his investors are looking for exposure to large-caps, with stocks such as Apple or Proctor & Gamble or through allocations to the S&P 500.

"Our clients would be more hesitant with the Russell 2000. But if you don't have a clear indication of where the market is going, it's probably a good idea to have exposure to the Russell," he said.

"It's a nice point-to-point so we don't have to worry about a barrier.

"We have this buffer and we always prefer buffers.

"The only issue is the cap and how high of a cap is acceptable based on your willingness to give up some of the upside," he said.

The 10% annual cap "isn't bad," he said, although - given the choice - he would not hesitate to go longer in maturity in order to raise or eliminate the cap altogether.

"Of course we'd rather have a higher cap. But you have the leverage. A little over 3.30% compounded every year, and all of a sudden, you're capped out. It's pretty good."

Overall, for investors seeking exposure to this asset class, the notes were attractive in many aspects, he said.

"This is definitely a product that meets all the criteria that our clients are looking for in a structured note. Do you have downside protection? Yes you do. Is it an easy to understand index? Yes it is. Do you have a good chance of getting some upside potential? Yes. Not as good as I'd like to see but it's good. And there is something else to sweeten the pot: the three-times upside leverage," he said.

"This is a pretty good one for us. I wouldn't put 100% of a portfolio into this. But it's a nice addition to an equity exposure," he said.

Derivative of derivative

Carl Kunhardt, wealth advisor at Quest Capital Management, also liked the structure. But he objected to the use of an ETF as the underlying, preferring the index.

"I don't have a problem with the terms and the structure of those notes. It's a plain vanilla, not very complex deal. But I don't like it because of what the underlying security is. I don't mind being tied to an index because it's only one moving piece. That same structure directly tied to the Russell index, I would've liked it. But here, you are tied to an ETF, which is another security; one that you need to make sure is actually mirroring the index," Kunhardt said.

One of Kunhardt's main concerns was the existence of tracking errors.

"No ETF is a pure replication of an index. There is always some dispersion," he said.

In addition, Kunhardt said that he did not see the point of investing in a note based on another security as it involves costs, illiquidity and errors that one can avoid when investing in the security directly.

"You're not investing in an index. You're following a single security. A structured note is a derivative. I am linking it to another derivative when my underlying is an ETF. Not only do I have to monitor where the index is moving, now I also have to monitor how the ETF is doing in relation to the index.

"The fact that there is a fee means that your return is never going to be when the index is. I'm always going to underperform the index.

"Don't get me wrong. I invest in ETFs all the time, but not through a note. When I buy an ETF, I can get in and out anytime. I am fully liquid.

"Why didn't they tie the notes directly to the Russell index? It's such a widely used index; you can get the options fairly easily.

"Having the index instead of the ETF would've made all the difference to me."

The notes (Cusip: 06366RJQ9) will price on Nov. 27 and settle on Nov. 30.

BMO Capital Markets Corp. is the agent.

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