JPMorgan’s $13.01 million of notes on MSCI EM, basket offer rare asset mix for a worst-of

By Emma Trincal

New York, May 17 – JPMorgan Chase Financial Co. LLC’s $13.01 million of 0% trigger gears due May 15, 2026 linked to the MSCI Emerging Markets index and an unequally weighted basket of five equity indexes present the particularity of putting together an index and a basket of indexes in a worst-of payout.

The diversification of the basket contrasted with the volatility of the index, sources said.

Most worst-of in equities bring together the same security type such as several indexes together or stocks together. ETFs are also often used as underlying in a worst-of. Occasionally, issuers combine indexes and ETFs.

But the use of a diversified basket with an index is rare, according to data compiled by Prospect News.

The basket consists of the Euro Stoxx 50 index with a 40% weight, the Nikkei 225 index with a 25% weight, the FTSE 100 index with a 17.5% weight, the Swiss Market index with a 10% weight and the S&P/ASX 200 index with a 7.5% weight, according to a 424B2 filing with the Securities and Exchange Commission.

If both the basket and the index finish positive, then the payout at maturity will be par plus 1.78 times the return of the least performing asset.

If either asset falls by up to 50%, the payout will be par.

Investors will lose 1% for every 1% decline of the least performing asset from its initial level if it finishes below the 50% downside threshold.

Emerging versus developed

“I wouldn’t do it,” said Carl Kunhardt, wealth advisor Quest Capital Management.

“It’s a play on developed countries versus emerging markets. All five basket components are developed markets. Everything else is window dressing.”

This adviser’s main concern was on the downside risk.

“It’s a generous barrier for a five-year note except that you’re dealing with emerging markets, which are extremely volatile. You’re going to have exposure to the worst-of. And we know that emerging markets can have huge turnarounds. You could have a nice ride for four years and emerging markets decides to blow up during the last year. You could be up 100% and down 200% the next year.

“So, you’re rolling the dice on emerging markets because that’s where volatility is going to be,” he said.

Basket limitations

Kunhardt said his main objection was the worst-of.

“I don’t like worst-of in general,” he said.

The five-year term was another concern.

“You’re giving up the dividends for five years, and we know that foreign dividends can be significant compared to U.S. dividends,” he said.

At first it seemed as if a diversified basket could offset the volatility of the MSCI Emerging Markets index.

“But that’s just an impression. It doesn’t work that way at all here,” he said.

“You’re putting a basket to mitigate the volatility of the MSCI Emerging Markets in theory. But all it does is mitigate your potential upside because you’re still exposed to the worst-of.”

Two scenarios

He suggested as examples two potential scenarios.

In the first one, the MSCI Emerging Markets index would be “on a tear,” leaving investors exposed to the more modest return of the basket or even its negative performance.

Another scenario could see the index value dropping much more than that of the basket. In this case, investors would not be in a position to take advantage of the risk mitigation benefits of the basket.

“You mitigate your upside with the basket without reducing the volatility of the index. What’s the point?” he said.

Some rules

Kunhardt said emerging markets are part of an international equity exposure. As an asset allocator, he invests in the asset class. But he does so with “extreme caution.”

“Do I want to make a call on emerging markets for five years? No way. I don’t even want to do it for next year,” he said.

“You can’t tell me what this index does because it’s all over the place.”

When investing in emerging markets Kunhardt follows a few simple rules.

His first rule is to learn about the individual countries.

“Emerging markets is a broad asset class. Investing in Malaysia is not the same as investing in Panama,” he said.

His second rule is to “never go passive but rely on active management.” The adviser says he uses mutual funds with reasonable fees.

Finally, rule number three consists of position sizing this asset class below 5% of the portfolio.

Opportunity cost

Jerry Verseput, president of Veripax Wealth Management, also pointed to the risk associated with the worst-of. But for him, the risk was rather on the upside.

“I like the barrier. I like the leverage. I can see why they needed the worst-of to get that leverage with no cap.

“But you’re not getting the leverage on emerging markets. You’re getting it on the worst-of. You can run in a situation where emerging markets does well, but you won’t be able to take advantage of the leverage on emerging markets. You’ll get the leverage on the basket,” he said.

Pure play

“If I want exposure to emerging markets, I’d rather do a note purely on emerging markets as opposed to adding confusion with those other foreign stocks in the mix.”

Verseput was comfortable with the downside.

“I don’t think you will be violating the 50% barrier in five years even with emerging markets. I think it’s unlikely,” he said.

High risk, high return

Even with a small chance of breaching the barrier, investors in this asset class should always be willing to take some losses.

“People design notes so they can never lose money. It’s not how you invest if you want exposure to emerging markets,” he said.

“You don’t have to have your entire portfolio in a risky asset class. A better way to control risk is to make a small allocation.”

Verseput had a different idea on how to recreate the exposure to the two underlings.

“I’d rather have a note purely focused on one asset class.

“If I wanted the basket exposure and the emerging markets exposure, I’d rather have it in two separate notes.

“But combining the two in one investment with a worst-of payout, that’s something I don’t really care for,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

JPMorgan and UBS Financial Services Inc. are the agents.

The notes (Cusip: 46652Y109) settled on Monday.

The fee is 3.5%.

© 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.