GS Finance’s notes tied to U.S. Real Estate ETF are expensive to hedge, contrarian trader says

By Emma Trincal

New York, May 4 – GS Finance Corp.’s 0% leveraged notes due July 5, 2019 linked to the iShares U.S. Real Estate exchange-traded fund are not a definite contrarian pick and hedging the notes would be expensive, said Steven Jon Kaplan, founder of TrueContrarian Investments, a value investor and trader with a contrarian approach.

If the fund return is positive, the payout at maturity will be par plus 160% of the fund return, according to a 424B2 filing with the Securities and Exchange Commission.

Investors lose 1% for each 1% decline from the initial level.

Screener

While not a buyer of structured notes per se, Kaplan said he is interested in identifying some notes as contrarian trades while being able to hedge them.

“Some deals – and there are not many – will offer a very attractive risk-adjusted return. Those notes I look at tend to be uncapped and for one reason or another are worth taking some risk on, especially if you can hedge it,” he said.

The deals Kaplan looks for should not only show a reasonable risk-reward profile. The timeframe is essential as well, as Kaplan is bearish on the U.S. market. By style he also seeks out-of-favor asset classes.

“Unfortunately, the notes I’m seeing are often linked to overvalued markets. I suppose retail investors may not be comfortable being contrarian. But it’s worth mentioning that unpopular stocks or benchmarks can greatly improve the economics of a deal. Sometimes I wonder why the Street is not trying to identify those contrarian investors. It would open new doors to them.”

No clear trend

The GS Finance deal did not exactly match the profile of what Kaplan is looking for.

For one, the iShares U.S. Real Estate ETF is not an obvious contrarian play, he said.

The fund offers exposure to U.S. real estate companies and REITs, which invest in real estate directly and trade like stocks.

“Over the past few years, it hasn’t done much. It has been less in demand but it’s still overvalued from previous years. I certainly wouldn’t want to hold it long term,” he said.

In 2014, the fund was up 27% but has not been going up very much since. It rose by approximately 9% last year underperforming the S&P 500 index by 13 points. This year, the fund is down 6%. The S&P 500 index lost 1%.

Time horizon

Kaplan was not sure whether the 14-month timeframe was right.

“There are two schools for why this asset class is cheap. You could see it as a bearish signal. We know that real estate led the way in 2007 by dropping ahead of the rest of the market. That’s a characteristic of this sector. If that’s your view, you are bearish and you should stay away from it,” he noted.

“Another argument you can make, and that’s the contrarian view, is that real estate stocks are not that popular right now and that they’re due for a rebound. That would be the reason to buy cheap. But in general I like to hedge my bets.”

Dividend cost

Overall, the trader did not have a specific view on the fund. But he said that buying the notes would require being very bullish.

“There are positives and negatives about this note,” he said.

On the plus side, having no cap and 1.6x leverage were attractive items especially for bulls.

The negative part was foregoing the high dividends associated with the underlying fund.

The iShares U.S. Real Estate exchange-traded fund carries a 3.85% dividend yield, which over the 14-month period represents about 4.5%, he noted.

By definition REITs will pay high dividends, he explained. Those trusts are required by the Federal government to pay out at least 90% of their earnings in dividends.

“Dividends represent a big part of your profit when you invest in REITs. Having to give up 4.5% in profit when you buy the notes is not great unless you’re really bullish,” he said.

The 1.6 leverage factor could offset the loss of dividends. But the price return of the underlying fund would have to be 7.5% over the 14-month period in order for noteholders to break even. Only above that threshold would they outperform the performance of the fund.

Tax law

Kaplan said that buying the notes would only make sense for someone confident that the fund would exceed that threshold.

“You have 1.6x leverage and no cap. But you lose 4.5% in dividends. That’s the trade off,” he said.

“I don’t like the idea of giving up dividends upfront...especially with REITs given the new tax law.”

The Tax Cuts and Jobs Act gives investors in REITs a 20% tax cut on the pass-through income received.

Costly short

Kaplan likes to hedge his bets. But this note would be “complicated” to hedge, he said.

The easy part is to simply short the ETF.

“It’s easy. But if you short you’re giving up dividends again. And that’s expensive.”

Short-sellers, who borrow the shares that they sell, must pay the dividends to the lender of the stock.

“If you hedge the note by shorting IYR you’re losing the dividends again. Overall, you’re giving up dividends twice – first for buying the notes and second, for shorting the underlying.”

The iShares U.S. Real Estate ETF is listed on the NYSE Arca under the symbol “IYR.”

Only for big bulls

Kaplan said he does not have a strong bullish conviction on the underlying.

“Whether the share price starts to rebound now or later in the year is difficult to tell,” he said.

“You can always hedge the trade. The fund is very liquid. It’s easy. But it’s expensive in terms of dividends.

“By using the note rather than buying the fund, you’re also giving up the great tax benefits introduced by the new tax law.

“It may be fine if you make it a bullish bet and you’re confident to be up more than the 7.5% break-even. But it doesn’t take care of your hedging cost nor does it allow you to benefit from the huge tax break.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. is the agent.

The notes (Cusip: 40055AZQ3) settled on Friday.

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