Wells Fargo's enhanced note on ETFs priced for Eksportfinans is for neutral, global investors

By Emma Trincal

New York, June 1 - Wells Fargo Securities, LLC's $6.25 million issuance of enhanced growth notes based on an exchange-traded fund basket may appeal to investors who are mildly bullish or mildly bearish on global equity or simply neutral, sources said.

However, investors take significant risk of losing money beyond the contingent principal protection due to some leverage applied on the downside, a feature that some sources criticized.

The agent priced the 0% enhanced growth securities with leveraged upside and buffered downside due June 5, 2014 for issuer Eksportfinans ASA, according to a 424B2 filing with the Securities and Exchange Commission.

The basket consists of the SPDR S&P 500 ETF trust with a 45% weight, the iShares MSCI EAFE index fund with a 20% weight, the iShares Russell 2000 index fund with a 20% weight and the iShares MSCI Emerging Markets index fund with a 15% weight.

The payout at maturity will be par plus 1.5 times any basket gain, up to a maximum payment of $1,620 per $1,000 principal amount. Investors will receive par if the basket falls by up to 20% and will lose 1.25% for every 1% decline beyond 20%.

20% protection

"You're long these big, global broad indexes," said Greg Feirman, financial adviser at Top Gun Financial Planning.

"They're capping the upside, and they're giving you some protection on the downside. If you're not very bullish and if you're not very bearish, if you believe the market will be range-bound, then you have a decent play."

Feirman said that as long as the basket does not decline by more than 20%, the notes will outperform a direct investment in the basket.

Once the basket value falls by more than 20%, the loss of principal is triggered and accelerated at a rate of 1.25 times the underlying decline beyond 20%. But investors will still have the advantage of the 20% protection provided by the buffer, as it reduces the overall amount of losses, Feirman said.

"If you lose 50%, your loss is 37.5%. So you do benefit from the buffer," he said.

He referred to a 30% loss - after the buffer absorbs 20% of the overall 50% decline - to which the 1.25% factor is applied.

Leveraged returns

Feirman said that he also liked the upside because of the leverage.

"If your basket is up 10%, you get 15%. If it's up 25%, you get 37.5%. You would have to get a market up 41% in order to reach your 62% cap. Anything below 41% and you can still capture all your gain. I like it a lot," said Feirman.

While the Russell 2000 and the S&P 500 represent the U.S. equity market, the iShares MSCI EAFE index fund tracks stocks in Europe, Australia, Asia and the Far East and the iShares MSCI Emerging Markets index fund corresponds to the global emerging market universe.

Asked whether he thought the 62% cap was high, Feirman said, "The cap is relative. It depends on your view."

Looking at the basket appreciation needed over the four-year term to get the maximum return - approximately 40% - he said, "If you're bullish, this cap is not that high. You could do much more than 40% in four years. But if you're not extremely bullish, it's not a bad vehicle."

Downside risk

Some of the basket constituents are highly volatile, sources said.

For instance, the iShares MSCI Emerging Markets index fund is down nearly 10% this year. Over the last five years, though, this fund rose by 62%.

The iShares MSCI Emerging Markets index fund, on the other hand, has shown losses both this year and over the past five years with negative performances of 13.5% and 8.50%, respectively.

Feirman said that the greatest concern for investors should be the possibility of losing their entire principal and not so much the risk of underperforming the basket as a result of the cap.

"The only risk is if you have a big bear market. And while I'm worried about that, the product is not a bad way to speculate," said Feirman.

Unusual put spread

An options trader analyzed the product as option components and said that he was not comfortable with the leverage factor on the downside.

"My capped upside is as if I was short a covered call. I don't have unlimited upside. When the stock goes up to the strike price - which is the cap - I've realized all of my upside," this source said.

He said that the downside could be analyzed twofold: One part is the buffer that provides full principal protection up to a 20% decline of the underlying basket. The other is the loss of principal that is triggered beyond the 20% threshold.

"You get a 20% buffer by being long a put," he said.

At the same time, the sudden ending of the protection when the basket falls by more than 20% is the equivalent of the investor selling a put, added this options trader.

"You have a put spread. You sell a put and with the proceeds you buy another put. The second put, the put you buy, protects you up to the 20% decline. The put you sell is how you get exposed to risk. If I short a put, I'm at maximum risk. I can lose up to zero minus my premium," he said.

Beyond 20%

However, there is a difference between selling a put and being exposed to downside risk at a rate of 1.25% for each 1% decline of the basket beyond the buffer, this source noted.

"You have downside protection, but the risk increases as the stock drops below the buffer. After the buffer, it's similar to being short a put except that the increase of the losses is faster than the basket decline. So it's not quite a short put because with a short put, you would only be losing dollar for dollar," this source said.

This options trader said that the leverage applied on the downside was not attractive to investors.

"I don't like that. On the upside, I can't make any more than the cap, but I can lose all my money on the downside. I could have a big move on the downside and lose a lot or even everything. But if I have a big move on the upside, I am capped," he said.

Fees are 2.75%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.