09/30/2014

3X Leverage – Conservative or Aggressive?

In July we broached the topic of leverage in a post titled “5X Leverage – Sane or Insane?” For those wondering, the answer was sane – the note should outperform the Euro Stoxx index it tracks if 5-year annualized returns, inclusive of dividends, are between 1% and 12%. Since the historical 5 year annualized return for Euro Stoxx is approximately 8.5% (assuming a 2.5%-2.75% annual dividend), outperforming the index so long as the index is below 12% is compelling.

Today I would like to examine a different leveraged structured note that has attracted significant investor interest – 3X strategies on the S&P 500 have attracted well over $1 billion in notional this year. I will focus on eight notes (here’s the most recent one) struck roughly a month apart over the course of the first eight months of 2014, each with a notional of over $100 million.

Typical terms were as follows:

• Tracks the S&P 500 with 300% upside participation
• 10.4% cap on the upside
• 100% downside participation (no protection)
• 14 month term

Why are we interested?

Typically, leveraged products, such as these 3X structured notes, are associated with a bullish stance on the market. For example, 3X ETF products are aggressive vehicles in which investors can reap substantial profits when markets move in their direction. However, these 3X notes, like the 5X notes we previously examined, are capped. Thus, these notes are superior to straight S&P investments only when the S&P performs moderately well – however, in runaway bull markets, the cap on the notes will lead to these notes underperforming the index.

Let’s do some technical analysis

To illustrate this, we will review hypothetical performance of the structured note verses the S&P 500 Total Return (assumes 2.0% dividend for the S&P over the 14 months)

Chart 1: Performance of S&P 500 Total Return vs. Structured NoteBlog chart 1

As can be seen in the chart, the note outperforms when the 14 month S&P Total Returns are between 3.0% and 10.4% (i.e., when the S&P Price Return is between 1.0% and 8.4%). If the S&P Price Return generates returns below 1.0%, it will slightly outperform the note due to the dividend payments of 2.0%. More interestingly, if the S&P Price Return is above 8.4% by term end, it will outperform this note.

Table 1: Performance of S&P 500 Total Return vs. Structured Note Blog Table 1
The table above illustrates that the note outperforms in mildly neutral markets, where the 12 month S&P Price Return is between 1.0% and 7.0%, and underperforms in markets returning below 1.0% and above 7.0% over 12 months (Assuming a 1.7% dividend over 12 months, the equivalent Total Return figures are 2.8% and 8.8%). For historical context, the net total annualized returns for the S&P 500 have been 24.5%, 19.8%, 16.1%, and 7.7% over the last 1, 3, 5, and 10 year historical periods[1]. The relatively low cap relative to historical performance has to do with market forces – the issuer is pricing this note based on both how much it can sell S&P-linked put options for (not much now, given low market volatility) and where interest rates are (i.e., how much bank treasury will pay to get use of investor capital; pretty low right now).

So while there is a headline grabbing 300% participation level, the fact that the cap is a relatively low 10.4% results in a strategy that is really neutral in character. The highest level of outperformance occurs when there is a meek S&P 500 price return of 3.3%, which equates to a total return of about 5.3%. In that scenario, the note returns 3X the price return of 3.3%, leading to an outperformance of 4.6% (9.9% vs. 5.3%).

One of the characteristics that attracted me to analyze this group of notes was that an almost identical note had been offered, by the same distributor, one month apart for eight months. It would appear the distributor is either promoting or responding to a desire for structured note diversification across time. For investors of structured notes, there is a strong case to be made to separate purchases across several months rather than make a single investment. Here’s why – as a reminder, this investment outperforms in neutral environments and underperforms in both down markets and bull markets. By spacing out purchases, an investor can mitigate the risk of a single purchase of a 14 month period which happens to be either down or way up.

There have been some recent articles on the benefits of time-based diversification for structured note investors; in addition, RBC Wealth Management has published a relevant white paper on the subject – “The Case for Layering Structured Products into an Equity Portfolio”.

Going back to the original question of leverage being conservative or aggressive for this investment, the low cap on performance is decidedly conservative (i.e., this note may not make sense for bullish investors), but the lack of protection and underperformance in down markets speak to a more aggressive position. The net impact of these features is the note outperforms in a low growth environment and disappoints in either a bear or bull market – perhaps the best description is the note is aggressively middle of the road.

In conclusion, while leverage is typically associated with aggressive market stances, it is critical to understand how a note is structured to conclude what return profile is really being offered – in this case, the investor profile is one expecting minimal market gains for the next 14 months.

 [1] Source: http://us.spindices.com/indices/equity/sp-500

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