HSBC’s long short notes tied to industrial/consumer discretionary index seek to capture alpha

By Emma Trincal

New York, July 24 – HSBC USA Inc.’s 0% long short notes linked to the Industrial Select Sector/Consumer Discretionary Select Sector Long Short index give investors access to a long-short play on two sectors, prompting advisers to ask whether the delta one product is worth the 2% fee.

The tenor of the notes is expected to be 16 to 20 months. The exact maturity date will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

The composite index consists of a leveraged long position in the Industrial Select Sector index and a short position in the Consumer Discretionary Select Sector index.

The long component will have an initial weight of 150%, and the short component will have an initial weight of negative 50%.

The payout at maturity will be par of $10 plus the index return. If that return is negative, investors will receive less than par.

The final index level will be the average of the index’s closing levels on five trading days shortly before the maturity date.

BofA Merrill Lynch is the agent.

Investors in the notes expect the industrial sector to grow and the consumer discretionary sector to decrease or not increase as much as the industrial component, the prospectus explained.

ETF preferred

The same view, assuming one agrees with it, could be implemented with exchange-traded funds, said Matt Medeiros, chief executive at the Institute for Wealth Management.

“My preference would be to use ETFs directly and replicate this strategy, or another strategy I might like, with ETFs. For one thing, it would give me more flexibility on how to express my view and how to revise it on a timely basis,” he said.

“Second, you have to pay a fee to get access to this strategy, but that’s pretty much all you have. You’re not offered any optionality. The structure is a mere tracker with no downside protection. Even if one of the components is leveraged, your exposure to the index itself is one to one.

“What really gives a note an edge is the downside protection. You don’t have it here.

“At least the ETF would give me transparency. I would have the liquidity and therefore the flexibility to change my view, and I wouldn’t be subject to credit risk.”

Fundamentals

The Consumer Discretionary Select Sector index is up 1.2% this year to date versus 3.2% for the Industrial Select Sector index. In comparison, the S&P 500 index has gained 7.6% since the beginning of the year.

The consumer discretionary sector tends to outperform in the early stages of an economic expansion. As a result, investors who believe that the U.S. economy has moved past that stage would be less bullish or maybe neutral on the sector, according to a July report on sector views by Charles Schwab & Co., Inc.

The bullish bet on industrials reflects the belief that global economic expansion will continue to hold. The fundamental picture is that Europe is out of its recession, China is still growing, and U.S. corporate balance sheets are sufficiently rich in cash to incite businesses to invest in new equipment, according to the report.

The notes allow investors to participate in a leveraged long position in the Industrial Select Sector index and a short position in the Consumer Discretionary Select Sector index.

Investors buying the notes would have to believe in this underlying theme.

No reason to short

“I’m not sure I agree with the underlying long/short strategy,” Medeiros said. “Both the discretionary and industrials sectors have had a good run. By shorting the discretionary, you’re making the presumption that the run is over. I don’t know that the run is over. Both sectors have performed well, and you’re assuming that one is not going to perform as well as the other.

“I don’t see any reason at this point to short either one or the other of these sectors.

“That’s not to say I wouldn’t short a particular sector or asset class given the right conditions. But I don’t see a strong bearish signal on any of those two sectors at this point.”

Medeiros said that he is currently long the industrial and consumer discretionary sectors in his large-cap position with a neutral rating.

“There is a place for notes linked to these types of strategies, but of course you have to have the right mixture of sectors in there and the underlying view has to reflect your own,” he said.

“I wouldn’t pay 2% for having a note put together reflecting a view on some sectors, even if it happened to be my view. Overall, I would prefer the cost-efficiency, the flexibility of doing something similar through ETFs.”

Correlation play

Steve Doucette, financial adviser at Proctor Financial, said the underlying strategy is interesting but would require him to do more in-depth research.

“I’d have to run the data. The two sector indexes have a crazy relationship. If you go back long enough on the chart, you’ll see that there is not a lot of correlation between the two. There is potential for reversion to the mean. That’s what the index is trying to capture. If what you’re doing here is trying to capture alpha out of the outperformance of one index over the other, it may make sense,” he said.

“You’re trying to catch the industrials performance on the upside on a leveraged basis and try to protect yourself if they both go down with a short on the discretionary component, assuming that it would go down faster. It happened in 2008 when the discretionary sector index got crushed much harder. But by the same token, with the short leg of this trade you’re potentially dragging down the performance of the industrials.

“Whoever buys this expects a rollover from discretionary to industrials.

“Here is my take on this. Expressing views on sectors is very tricky. The timing is just very hard. On top of that, these two asset classes appear to be too volatile to try to structure a note here. And this is somewhere around a year and a half. It’s hard to catch alpha in a short timeframe.”

But Doucette was still intrigued.

“I would still need to do my research. If I did, I may like it.”

The cost of alpha

Assessing the true cost of the notes depends on how much investors value access to a complex strategy, assuming of course that they agree with the strategy, he said.

“Let’s assume I want to implement the long leverage industrial/short consumer discretionary play,” he said.

“How much fee do I need to pay to get this delta one index? It is a 2% fee. The pricing takes a big chunk of your return over time.

“On the other hand, they’re running the options component. If managing these things takes time, you’d have to take this into account when assessing the cost.

“I’d have to look at it. It’s a simple delta one tied to one index, so you may wonder how much fee you need to pay for it. There is no downside protection, no leverage at the notes level. Yet, one index component is levered out, so you can’t really say this is just one to one.

“There is built-in optionality in the notes. That’s what they’re doing. They’re just doing it at the index level. If you buy into the index and it’s reasonably priced, there is no reason why you wouldn’t try to pick it up in a note.

“I know that we’ve done a lot of delta one notes, in particular in the volatility space. I have no problem with the concept of a tracker note tied to a smart beta index or a strategy designed to generate alpha.

“If it gives you access to something that would be hard to manage on your own, then it has some value.”

The notes are expected to price in August and settle in September.

© 2015 Prospect News.
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