HSBC’s leveraged performance notes on HSBC Vantage5 index face objections due to underlying

By Emma Trincal

New York, April 2 – A proprietary index may have an attractive methodology and back-tested data, but if it’s a new index and if advisers fail to understand how it really works, they will not seek exposure to it through a structured note no matter how attractive the terms of the product may be.

This at least was the main opinion of two registered investment advisers who are not familiar with the HSBC Vantage5 index (USD) Excess Return used as the underlying of a five-year principal protected note.

HSBC USA Inc. plans to price 0% leveraged performance notes due May 1, 2023 linked to the HSBC Vantage5 Index (USD) Excess Return, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus at least 215% of the index return. The exact participation rate will be set at pricing.

If the index falls, then the payout will be par.

The index

The HSBC Vantage5 Index (USD) Excess Return strategy was created in March 2017. It dynamically allocates its weightings each month to a basket of 13 exchange-traded funds and cash, aiming to deliver a volatility of 5%.

The constituents of the indexes are ETFs classified in certain asset class groups, which are capped. There is a weight cap for the individual ETFs as well. For instance, developed equities as a group is capped at 60%, developed bonds at 80%, emerging markets (bonds and equity) at 30%, real assets (real estate and gold) at 30%, inflation at 5% and cash at 50%.

Momentum and low vol.

The index uses a rules-based methodology to capture performance and maximize risk-adjusted returns, according to a fact sheet on the HSBC Vantage5 Index (USD) Excess Return posted on the HSBC website. The composition of the index is rebalanced each month to capture long and short-term momentum. The index algorithm determines allocations for the basket of 13 ETFs to achieve a volatility target of 5%.

Yield

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he could not find enough information in the prospectus and the fact sheet to be comfortable with the index.

The dividend yield was not seen. Yet its value matters as noteholders must forgo dividends.

“That’s the nature of the beast with structured notes. Unfortunately, I can’t find any information that would give me an idea of the yield; so, I have no idea of how much I am paying for,” he said.

He was referring to the dividend yield only. On the other hand, the fee was reasonable at 3.75% for five years, he said.

“That’s 75 basis points a year. That’s not terrible. We could definitely work with that,” he said.

Back testing

Another issue for Kalscheur was the novelty of the index, which is just one year old.

The performance prior to inception is calculated on a hypothetical back-tested basis.

“This index has been around for only a year. But we don’t have actual historical data. All the historical data we have is only one year old. Everything else is back testing. I don’t put very much stock in back testing. We all know that it’s not very accurate.

Protection and risk

Finally, even the value of the full downside protection was not as appealing as initially thought, he added.

“It’s got the downside protection, which is great. But over a five-year time period, what are my chances of being down with a volatility target of 5%?” he said.

“The terms of the notes are very impressive: leverage, no cap, downside protection.

“But I can’t get my arms around this index. Therefore, we wouldn’t consider this note.”

Muted returns

Carl Kunhardt, wealth adviser at Quest Capital Management, said that the volatility target of the index at 5% was sure to dampen the returns of the portfolio.

“Because of the rules they impose on themselves to limit the volatility of this index, even if you have a bunch of risky assets to choose from, at the end of the day, they will add enough cash and bonds to keep the volatility at 5%. That’s not going to give you a stellar return,” he said.

“The fact that they can put up to 80% in bonds and 50% in cash tells me that in order to meet their objective of no more than 5% volatility, you could get into a zero risk, zero return portfolio.”

Having more than 2x leverage was attractive. But if the return is weak, the leverage is not going to do much, he said.

“Best case scenario you get 3% a year. The leverage is going to give you less than 7%,” he said.

It did not seem so bad especially with the principal protection. But Kunhardt said that investors had to consider macroeconomic factors too.

“Rates are going up. Your bond allocation is in funds. So this bucket of investment will go down in price. Cash gets you nothing,” he said.

“You’re limited on how much equity you can put in there. You’re not in control of managing your allocation.”

In conclusion, the terms of the notes were not as attractive as they seemed in the first place.

“In order to target the volatility at 5%, their allocation is going to be so conservative that the principal protection is almost irrelevant. The cap is certainly irrelevant.

“I wouldn’t do it,” he said.

Since the index was launched a year ago, HSBC USA Inc. has issued 14 deals linked to the HSBC Vantage5 Index (USD) Excess Return totaling $12 million, according to data compiled by Prospect News. HSBC was the sole issuer of notes linked to this index.

HSBC Securities (USA) Inc. is the underwriter.

The notes will price on April 25 and settle on April 30.

The Cusip number is 40435FXS1.

© 2015 Prospect News.
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