Bank of Montreal’s absolute return notes linked to MSCI EAFE ETF offer international exposure

By Emma Trincal

New York, Aug. 18 – Bank of Montreal’s 0% contingent risk absolute return notes due Aug. 31, 2016 linked to the iShares MSCI EAFE exchange-traded fund provide international exposure to developed countries with an absolute return feature that allows for gains even if the ETF declines up to a point.

However, the use of an ETF instead of the index itself and the type of barrier employed for the contingent protection and absolute return payout are seen as drawbacks by some sources.

A barrier event will occur if the ETF’s closing share price is less than the barrier level on any day during the life of the notes. The barrier level is expected to be 74% to 78% of the initial share price and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the ETF return is positive, the payout at maturity will be par plus the ETF gain.

If the ETF return is zero or negative and a barrier event has not occurred, the payout will be par plus the absolute value of the ETF return.

Otherwise, investors will be fully exposed to the ETF’s decline from the initial price.

Carl Kunhardt, wealth adviser at Quest Capital Management, said he likes the notes even though he would have preferred to see the MSCI EAFE index as the reference asset instead of the ETF.

“It’s an interesting little note,” he said.

“I like it in spite of a couple of things.

“First, I typically don’t like notes that are tied to an ETF because you have to deal with the expenses. By definition, the ETF is going to slightly underperform the index by the amount of fees. The ETF reflects that expense, which is why it never tracks the index perfectly. When investing in the fund, you have to accept this underperformance.”

The iShares MSCI EAFE ETF seeks to track the performance before fees of the MSCI EAFE index. The fund carries a fee of 34 basis points.

The MSCI EAFE index tracks the equity market performance of developed market countries excluding the United States and Canada. It consists of 21 developed market countries with the largest weights in Japan (19.56%), the United Kingdom (17.52%), France (10.21%), Switzerland (9.71%) and Germany (9.32%).

“Investors are going to have to pay for not investing directly in an index. That’s a 34 basis points cost without even mentioning the fees charged by the issuer for structuring the deal itself,” he said.

Another inconvenience, Kunhardt noted, is the nature of the barrier, which can be breached on any given trading day (American barrier) as opposed to only at maturity (European barrier).

“There is more risk with that type of barrier, but I still like the deal,” he said.

“To me, these issues are overcome by the fact that it’s a very short-term note. They give you a very nice safety net of 22% to 26%. You get downside protection above the barrier level, but not only that, you get the benefit of the absolute return, which allows you outperform the underlying fund.

“I can see using that in my international portfolio. It gives you international exposure, a safety net, the possibility of outperforming the underlying on the downside and a reasonable liquidity since it’s only two years.

“This absolute return feature is really neat because it accomplishes two things: it gives you some safety, and it’s also a nice form of return enhancement.”

European focus

The ETF has a strong concentration in European stocks. Out of the 21 countries represented in the index besides the top ones (United Kingdom, France, Switzerland and Germany), the ETF includes several other European countries such as Austria, Belgium, Denmark, Finland, Ireland, the Netherlands, Norway, Portugal, Spain and Sweden, making for almost two-thirds of the total.

“Some investors may not like the European concentration, but that’s the case of almost any international index if you exclude emerging markets,” Kunhardt said.

“Anytime you’re getting a broadly diversified international portfolio that doesn’t focus exclusively on emerging markets, you’re going to get a big allocation to Europe.

“Unless the fund is emerging markets only, you’re not going to get more than 10% to 15% in emerging markets, and the rest will be split between Canada, which you don’t have here; Australia; New Zealand; Japan and what else? The rest will be Europe.”

Positive terms

The absence of leverage on the upside is acceptable given the return enhancement provided by the absolute return, he said.

“The upside is fine. It’s the fund return without a cap, so you’re basically long the fund,” he said.

“Overall, they’ve put bells and whistles to make this deal attractive despite the fact that they’re tracking an ETF instead of an index. It would have been better to get a barrier observable at maturity of course, but the barrier level and the term of the notes still make it an attractive play if you want international exposure.”

Michael Kalscheur, financial adviser at Castle Wealth Advisors, agreed that the terms at first appear attractive. But the barrier is not an option, in his view.

“At first glance, there is a lot to like when you see this note. It is relatively short-term. The contingent protection is up to 25%. Absolute return products are very appealing. The notion that you could be up significantly in a down market ... that’s the allure of these products,” he said.

“The market is down 20% and you’re up 20%. Who wouldn’t want that? Unfortunately, statistically speaking, it’s very difficult to get to that result.

“First, you don’t know when the dip is going to be. If you’re lucky, the market is going to be down 20% on that particular day without going below the barrier. Statistically speaking, is this index going to be down more than 25% within the next two years? Sure.”

Past performance

Kalscheur looked at the respective performances of the MSCI EAFE index and the S&P 500 index between their peak in October 2008 and their trough in March 2009.

During that time, the MSCI EAFE index fell by 58.5% and the S&P 500 index declined by 50.9%.

“During the same time the EAFE dropped just as much as the S&P 500 and more,” he said.

“The EAFE index has a beta of 0.97, which indicates not much more volatility than the S&P. It’s roughly in line with the U.S. benchmark even if it did a little worse during the financial crisis.

“Given what happened at that time, a 58% drop in just five months, is it possible that the market would be down by more than 25% in two years? Absolutely.”

American barrier

But the biggest drawback in Kalcheur’s view is more the barrier type than its level as the barrier can be breached any day, increasing the odds of losing the dual benefits of the downside protection and absolute return.

“If at least it was a final barrier, I could make an argument that two years from today, while the market is fairly priced you still have a chance to benefit from the structure, including the gains on the downside. You can take the bet that in two years, the fund will not be down by more than 25%. Maybe it’s a roll of the dice that I’m willing to take, but I may take that bet,” he said.

“But instead of that European barrier, you have an American barrier. You can lose your protection and potential absolute return any time in two years. That’s a very different type of risk.

“As soon as you say American barrier, in my mind, it’s a deal-killer. Every couple of years we can have a correction, the market can be down 20%. It’s very typical. Could we have another recession that pulls us down 26%, 27%? Yes. If it can happen any day, it’s entirely possible. We’re not talking about a black swan.

“While this note has some redeeming qualities – its payout, the short term, the issuer’s credit – I just can’t get excited about it. I can’t take the risk of losing the protection on any trading day. It’s just too easy to be down that level at any point of time. I can’t justify taking that type of risk for the types of clients that we have. I’m just not a big fan of barriers in general, but this American type of barrier, it’s just kind of a non-starter.”

The notes (Cusip: 06366RVY8) are expected to price Aug. 27 and settle Aug. 29.

BMO Capital Markets Corp. is the agent.

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