Citigroup’s notes on Citi Dynamic Asset offer protection, come with opportunity costs

By Emma Trincal

New York, Nov. 20 – Citigroup Global Markets Holdings Inc.’s market-linked notes due Nov. 30, 2027 linked to the Citi Dynamic Asset Selector 5 Excess Return index would not be a note contrarian investor Steven Jon Kaplan would recommend his clients.

The structure offered good features, said the founder of True Contrarian Investments, at the exception of the long maturity. His main objection was the rules-based index, which reflected an investment strategy opposite to his.

The payout at maturity will be par plus 1.2 to 1.45 times any index gain, according to a 424B2 filing with the Securities and Exchange Commission.

If the index finishes flat or falls, the payout will be par.

The index, which is published by Citigroup Global Markets Ltd., is based on a trend-following investment strategy.

“I would be reluctant to rely on an algorithm put together by a bunch of math PhDs,” Kaplan said.

“Also, it’s a relatively new index, so you don’t really have much data to test it.”

The index was created in 2016.

Trend, volatility signals

On each day, the index identifies current U.S. equity market conditions as falling within one of four possible “market regimes” based on trend and volatility signals, according to the prospectus. The trend signals reflect equity performance (upward or downward) while the volatility signals are based on whether realized volatility is higher or lower than 15%.

Depending on the identified market regime, the exposure is allocated to one of three possible investment portfolios – equity-focused portfolio; Treasury portfolio; and intermediate portfolio. Each portfolio has a predetermined allocation to two constituents: S&P 500 futures and 10-year Treasury futures.

One characteristic of the model is its significant exposure to the U.S. Treasuries compared to equities.

In two of the three possible portfolios, the Treasury constituent will be either two-thirds or the full weight of that portfolio. The equity weighting never exceeds two-thirds and can be 0%.

Interest rate risk

Kaplan’s criticism focused on the Treasury allocations of the model.

“You can take a serious potential loss with Treasuries if you’re buying now,” he said.

“Interest rates are not going to stay as low as they are right now indefinitely. How much could they rise is a complicated question.

“But inflation is going to come back, and rates will begin to rise. Your exposure to interest rate risk should be a red flag.”

Toppish markets

Current market conditions make the investment even riskier due to current asset valuations in the overall market.

“The Treasury market is overvalued and so is the stock market. You’re buying two overpriced, overbought asset classes,” he said.

The model does not prepare investors for the risk of a double bear market in both bonds and stocks, he said.

The situation is atypical because Government bonds in the past were used to hedge declining stock markets.

“It’s not the case anymore,” he noted.

“In 2000 and 2007, both stock prices and interest rates were high. It made sense to buy Treasuries. They were cheap and it was a way of balancing out stock market losses.

“It no longer works that way. Treasuries collapsed during the March bear market. It’s not that they’ve become overly correlated to stocks. It’s just that bonds and stocks are both overvalued.”

Volatility target

The note however offers ways to mitigate risk. The main one is the full principal protection at maturity.

“This may be a selling point,” he said.

“Having full principal protection is certainly good. It provides the benefit of safety. But even without a specific market loss, you’re missing a lot of opportunities over the course of seven years.”

The volatility-targeting feature was also designed to add another layer of safety. The algorithm may at any time reduce exposure to its selected portfolio to maintain a volatility target of 5%. This is done by increasing the allocation to cash.

However, such rebalancing may dampen the potential for equity returns, warned the prospectus.

A separate factor may also dampen equity returns: the choice of 15% as a threshold for elevated volatility since 15% is below the historical average, the prospectus added.

“Sometimes it’s a good thing to add cash to the portfolio or reduce its volatility. But you can’t be too rigid.

“What’s more important is what you’re going to do with your cash and for how long... How are you going to redeploy it when the market turns,” he said.

Signal flaws

The prospectus pointed to the signal-based allocations as another risk factor in, stressing that the signals may not respond to changes in the market fast enough. The potential time-lag between the beginning of a trend and the time at which the signal will pick up the trend may cause the index to underperform in some markets, especially in choppy markets which lack long-term consistent trends and display fast-moving volatility.

Price momentum

Kaplan said he is not a believer in trend-following, the strategy around which the algorithm is built.

Trend-followers believe in the momentum of prices. They expect a rising market to continue to rise, buying stocks when the trend is up and selling when it’s down. Contrarians are inclined to do the opposite.

“Trend-following may work for short periods of time, but usually it doesn’t. When everyone is chasing the same returns you don’t have an edge,” he said.

“Even if the index rebalances daily there are inherent flaws in trend-following. Many academic studies have shown that the market doesn’t work that way. Trend-followers buy high and sell low. It’s hard to generate consistent profits with this approach.”

The human touch

Contrarian investors, such as Kaplan, recognize the importance of human emotions, he said.

They buy during market panics and sell when investors are euphoric and complacent, he explained. Such approach is not part of the index methodology.

“This index doesn’t take into account the real world. There is no signal in this system that looks at where the crowd is so you can do what the crowd is not doing.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes will price on Nov. 24 and settle on Nov. 30.

The Cusip number is 17328WYN2.

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