RBC, Barclays offer iShares MSCI Emerging Markets-linked notes with less risk but capped gains

By Emma Trincal

New York, Oct. 7 - Demand remains strong for emerging markets exposure, and several recent deals seek to offer that exposure through the iShares MSCI Emerging Markets index fund.

In one of those future deals, Barclays Bank plc will price 0% buffered Super Track digital notes due April 30, 2012 linked to the exchange-traded fund, according to an FWP filing with the Securities and Exchange Commission.

If the ETF's final share price is greater than or equal to the initial share price, the payout at maturity will be par plus a fixed payment that is expected to be 9.75% to 12.5% and will be set at pricing. Investors will receive par if the share price declines by 10% or less and will lose 1% for every 1% that it declines beyond 10%.

Separately, Royal Bank of Canada plans to price 0% leveraged buffered notes linked to the iShares MSCI Emerging Markets index fund, according to a 424B2 filing with the SEC.

The tenor of the notes will be 20 to 23 months.

The payout at maturity will be par plus 110% of any increase in the ETF's share price, subject to a maximum return of 18.7% to 22% that will be set at pricing. Investors will receive par if the share price falls by 15% or less and will lose 1.1765% for every 1% that it declines beyond 15%.

Both notes offer partial protection, have approximately a two-year maturity and are linked to a well-known emerging markets benchmark, said Steve Doucette, financial adviser with Proctor Financial, who compared the two products.

"The underlying concept is fine. In two, three years, there is an opportunity for gains in the emerging markets," he said. "Yet, neither will get me excited."

Risk for clipping

"With the Barclays [notes], you're taking market risk to collect a coupon. A 10% buffer is nice. But if it goes below, you're subject to the equity downside just to collect a fixed rate. You tie your money to a 90% equity downside risk for that. I just don't like this combination in any note. If I want some coupon, I'll go and look for an income-producing product with less risk."

Uneven leverage

Doucette said that the leveraged RBC product made "a little bit more sense" but only to investors who believe that the underlying emerging markets ETF will move with moderate volatility.

"If you believe you're in trading range, you might get a little leveraged return with a little protection if it goes the other way," he said.

But Doucette said that he would not consider this product either due to two factors: the cap and the downside leverage.

"If I take emerging market exposure as part of a diversified portfolio, I'd have to be looking for an investment that doesn't have a cap on the upside. The cap works for you if you think the fund will trade sideways. But this is not my view," he said.

He then pointed to the 1.1765% leverage on the downside for every 1% the fund loses beyond the 15% buffer. He compared it to the 1.1% leverage factor on the upside.

"It's ridiculous. I would never take a higher leverage on the downside than on the upside," he said.

Summarizing what he would be looking for if he was in the market for a two-year product linked to the iShares MSCI Emerging Markets fund, Doucette said, "I would want less of a buffer; I would get rid of the downside leverage; and obviously I would be looking for the best possible return. I would not want a cap."

Cut both tails

Richard Kang, chief investment officer and director of research at Emerging Global Advisors, looked at both products and said that both were designed to "cut tail risk."

"I think what's striking is that you're trying to modify the skew. You're trying to cut both tails, the returns and the risk," he said.

He was referring to the existence of either a cap or a fixed coupon as a feature that limits returns and to the buffer as a way to cut risk.

"If the market crashes, you remove some of the risk. But if things go up dramatically, you also remove a big chunk of the gains," he said.

Kang said that some long/short hedge funds may be able to do just that and not necessarily at a higher cost.

"If the manager picks really good long positions, you have a really good potential for upside while the shorts limit your downside as well," he said.

But the question is not so much whether a hedge fund can do a better job for less, he said. Rather, it's the investor's view on emerging markets that will determine whether the note is the appropriate investment, he said.

"Investors need to define for themselves if they want to reduce tail risk with emerging markets. If they do, then great. These notes are going to do it, because they're engineered to do it," he said.

For bullish investors though, the capping of the gains may defeat the purpose of being long emerging markets in the first place, he said.

"Emerging markets are one of the few places where you really want to accept volatility because you're going to be pretty well compensated for it," he said.

The Barclays notes (Cusip 06740PTP1) will price Oct. 26 and settle Oct. 29.

Barclays Capital Inc. is the agent.

Goldman, Sachs & Co. is the underwriter for the RBC notes.

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