Credit Suisse's market neutral equity ETNs introduce use of classic hedging tool in a note

By Emma Trincal

New York, Sept. 19 - Credit Suisse AG, Nassau Branch's planned 0% market neutral equity exchange-traded notes due Sept. 22, 2031 linked to the HS Market Neutral Index Powered by HOLT will be one of the first ETNs to offer investors a popular hedge fund strategy called equity market neutral in a note format, a market participant said. It's also the first use of the underlying index in a structured note, he noted.

"To my knowledge, it's the first time an equity market neutral strategy is being delivered in a note format," he said.

"You have some [exchange-traded funds] based on market neutral that launched recently, but not ETNs, to my knowledge."

The HS Market Neutral index uses a strategy popular with hedge funds where the main aim is to achieve stable returns. The emphasis is on reducing risk rather than maximizing outperformance, according to a 424B2 filing with the Securities and Exchange Commission.

About 75 stocks are held on the expectation that their share price will go up (long position), and the same number of stocks are held on the expectation that their share price will go down (short position).

"It's a 100% long/short offset portfolio. They buy the best and short the worst in the same sector," said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

"You're only taking exposure to the difference between the best and the worse; you're not taking market exposure. I like it."

HOLT

The stocks are selected using the HOLT methodology. They are picked in any industry and must be listed in the United States, Canada, the United Kingdom, France, Germany, Italy, the Netherlands, Spain or Japan, according to the prospectus. Each exposure on the long side is matched with exposure on the short side, resulting in neutral overall exposure.

Equity market neutral strategies are often used as a hedge against market downturns because they offer low correlation to the overall equity market.

The correlation to the S&P 500 with HOLT is "only 30%," the market participant said.

What's out there

Another products using market neutral strategies have been recently introduced.

On Sept. 7, FFCM LLC announced QuantShares, a family of seven market-neutral ETFs based on specific factors: momentum, quality, size, value and beta, according to a press release.

Some structured notes have employed market neutral strategies before but in other asset classes.

For instance, SG Structured Products, Inc. priced 1.5% annual income notes due April 13, 2018 linked to the SGI Smart Market Neutral Commodity index, a commodity-linked product.

Now equity investors have expressed interest in those strategies with volatility in the stock market going through ups and downs.

"Demand for it is mostly coming from institutional investors and ultra-high-net worth, but the [registered investment adviser] community is also showing some interest," the market participant said.

"People want market exposure but in a less volatile manner," he added.

Market neutral benefits

Carl Kunhardt, wealth adviser at Quest Capital Management, said that he is interested in the product as a way to reduce the overall volatility of a portfolio.

"I am a fan of non-correlated investments. I like alternative investments," he said.

"I have at least 10% alternative investments in my portfolio, although it includes real estate.

"I am very comfortable with the concept of market neutral. But I would need to do research on the index itself. I'd want to understand the index before jumping in.

"I may prefer a little bit more flexibility in the weighting of the long and the short. Perhaps not fifty-fifty. But then, it wouldn't be market neutral."

Kunhardt explained why he likes market neutral strategies as a way to reduce risk.

"Imagine you're doing research in a hypothetical soda market and that you like Coca Cola. You like the stock, but through your research, you found competitors that you may not like. You may like Coke and not like Pepsi," he said.

"So here you are: You take a long position in Coca Cola and you short Pepsi. If you're right on both sides, you double your gains. If you're wrong on both sides, you double your losses.

"The positions by themselves may be very risky, very volatile. However, the low correlation drags the entire standard deviation down. Market neutral reduces the risk not in the position, but in the way it plays in the portfolio."

Kunhardt said that a 30% correlation with the market is "a little bit high compared to some other market neutral strategies that have a correlation in the low twenties."

"The lowest correlations are found in managed futures," he said.

"A 30% correlation is not the lowest, but for equity, it's not bad," he said.

Sector neutral

"This strategy is country neutral, sector neutral and currency neutral. Each long position in a sector is offset by a short position in the same sector," the market participant said.

"I like that it's sector neutral, geography neutral. That way, I'm not making a bet on a sector or region," Kunhardt said.

"I like that it's in 10 different sectors. I'm not taking concentrated bets. And the shorts and the longs are in the same sectors. It makes me feel more comfortable. You're not going to be long technology without hedging it.

"It's easy to explain to the client," Kalscheur said.

Kalscheur said the recent returns of the index - introduced in 2007 - are attractive. However, he would look at the simulated performance - back-testing - of the years before with more caution.

"When the market crashed in 2008 and 2009, they held their own. When it rallied in the middle of 2009 and 2010, the results were muted. The strategy is doing its job," he said.

"I'm not a big fan of back-testing. But the historical returns since September 2007 are pretty good."

Kalscheur said that investors would need to be comfortable with the "black box" nature of the underlying quantitative strategy, so called because the methodology for the calculation of the index follows very strict rules that are not easily understood by investors.

Black box

"It's a black box. They're not going to tell you what's in it, and I understand. If they did, everybody would be using their model, and who would need Credit Suisse?" he said

"Now, I am sure that if I sit down with them, they'll explain to me what I need to know about their stock selection process but without all the details. And that's fine. It's a proprietary methodology.

"What's in there is definitely a hedge. Anytime you're putting something in a market neutral box, you're hedging something.

"But you have to believe in the HOLT system, the index construction system they're coming up with.

"You're not buying a manager expertise but a black box expertise. Nothing wrong with that, but you have to be comfortable with it."

Cost

A "black box," however, offers cost advantages, both financial advisers said.

"I have hedge funds in my portfolio, and I like the idea of buying the manager skill. But a black box reduces your cost. You don't have to pay 2% and 20%," said Kunhardt.

He referred to the set of fees - a management fee of 2% of the assets and a performance fee of 20% of the profits - that investors typically pay their hedge fund managers.

"The concept, the product is not unique by any stretch of the imagination, but the 1.05% fee is very good in that space," said Kalscheur

"There is an actively managed market neutral fund that has no net market exposure - JPMorgan Multi-Cap Market Neutral (OGNAX). They have one for long/short offset, but their expenses are much higher at 1.95%.

"There are also some ETFs. The recent QuantShares seem to work very much the same with expense ratios in the 0.80%-0.85% range.

"I like the Credit Suisse product because it is broad based, but I also like the QuantShares because you can customize it based on the client."

Kalscheur said that market neutral strategies are good for investors in a down market as they help reduce losses. The launch of the new ETNs may prove timely with the recent surge in volatility.

"You do well when the market is not doing well, and you keep some powder dry," he said.

"That's why people hold bonds or cash.

"The market could be up 20% and you're doing only 18%, so you're slightly underperforming, but it's not much. On the other hand, the market may be down 20% and you only lose 10%; you're outperforming the market quite a lot.

"The question is when do you harvest your gains? ... I would be hesitant to get into a 24-month lockup note with something like this. But with an ETN, you don't have that problem. You can sell it anytime. And that's what interesting about it."

Pricing Tuesday

The notes are callable at any time, and they are putable subject to a minimum of $1 million principal amount and a redemption fee of up to $0.03 per note, according to the prospectus.

The daily investor fee is 1.05% per year.

The issuer will apply to list the notes on NYSE Arca under the symbol "CSMN."

Credit Suisse plans to sell up to $100 million of the notes. The agent will price a portion of the notes at par on Tuesday. The remainder of the notes will be sold from time to time at varying prices.

Credit Suisse Securities (USA) LLC is the agent.

The Cusip number is 22542D720.

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