Cap too low for bulls, advisers say about UBS’ $1.56 million buffer gears on Russell 2000

By Emma Trincal

New York, Sept. 19 – UBS AG, London Branch’s $1.56 million of 0% capped buffer gears due Sept. 18, 2025 linked to the Russell 2000 index offered attractive terms but the cap level would not be a good fit for bullish investors, advisers said.

The payout at maturity will be par plus double any index gain, capped at par plus 25.7%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 15% and will lose 1% for every 1% decline beyond 15%.

Successful merger

Steven Foldes, wealth manager and founder of Evensky & Katz / Foldes Financial Wealth Management, said he liked the issuer’s creditworthiness and the underlying.

“UBS has a strong credit based on its CDS spreads. Apparently, the acquisition of Credit Suisse was a pretty successful operation,” he said.

After its collapse, Credit Suisse was acquired by UBS in March in a deal engineered by Swiss regulators to prevent a global banking crisis.

UBS AG’s five-year credit default swap rates are at 64 basis points, according to S&P Global Market Intelligence. The spreads compare favorably with U.S. banks’ cost of insuring default risk. Only JPMorgan has tighter spreads than UBS at 58 bps. The other top U.S. banks have spreads ranging from 73 bps (Citigroup) to 85 bps (Goldman Sachs).

Reversion to the mean

Foldes also liked the underlying for its valuation.

“The Russell has significantly underperformed the S&P so far this year but also last year. It’s way out of favor relative to large-caps,” he said.

The Russell 2000 index has only gained 3.6% year to date while the S&P 500 index has jumped 15.3%.

Last year, the S&P 500 lost 18% and the Russell dropped 20.5%.

“Over time, underperformers swing back and revert to the mean. So, we think there’s a lot of potential growth in small-caps,” he said.

Stumbling block

“I like the underlier.

“I like the two-year. Our sweet spot is between one and two years.

“We like all of that,” he said.

But Foldes said he did not like the cap “at all.”

“Over the next two years, getting a cap of 11% a year is on the low side assuming you expect some kind of rally in this area, and we do have such expectation given how poorly the Russell 2000 has performed so far,” he said.

The 23.9% cap over two years represents an 11.3% annualized compounded return.

“I wouldn’t like to get a cap that’s as low as the historical performance of this index,” he said, adding that in the last 100 years, the Russell has returned between 11% and 12% per annum.

“The idea of getting that kind of result from an index that has been so depressed is a non-starter for us,” he said.

Alternatives

Foldes would reconstruct the notes aiming at a more aggressively bullish profile.

“I would rather see the buffer go away. We don’t think we need it,” he said.

If necessary, Foldes said he would be willing to cut the leverage multiple from 2 to 1.5 while eliminating the buffer. His goal would be to offer his clients the opportunity to get uncapped leveraged upside.

“We want the full participation with some leverage in order to capture the small cap run we expect to see over the period, especially if the Fed stops raising interest rates,” he said.

“I like the note. But I would like it a lot more without such a low cap.”

Low expectations

Another financial adviser agreed that the cap was “not that high.” But the structure, including the cap, may be a good fit for a more conservative investor.

“It’s a very straightforward note. Sometimes, boring is nice,” this adviser said.

“My philosophy is that if I take equity risk, I want an equity-type of return.

“The cap is not huge. But at least, it’s high enough to justify the risk I’m taking. I like the fact that it’s over 10% a year.”

For investors with modest expectations of return, the leverage was another positive.

“With 2x, I have a decent chance of outperforming if the market doesn’t do very well,” he said.

Indeed, an increase in the Russell 2000 index of only 5.8% a year would be enough to get the performance of the note to its maximum.

Outperforming bucket

The buffer was useful too. It guaranteed that the note would outperform the index in a negative scenario, he added.

Overall, investors would outperform if the index finished negative and positive up to 123.9%.

This adviser looked at back-testing data, zeroing on two-year rolling periods. He found that the Russell 2000 fell within the outperforming range 56.3% of the time.

“That leaves you with a chance of going over the cap of 43.7%. That’s a bit high but I’m still likely to outperform a long position,” he said.

The odds of a loss beyond the buffer are 7.9%.

“If it was a barrier, I’d be very hesitant. But with a buffer, I’m fine,” he said.

On the bright side, the index will finish up and below the cap 37.7% of the time, which is the best range to beat the index on the upside.

“If you get mid-single digit returns, you’ll easily capture the maximum return thanks to the leverage.”

Recession, profile

The timing of the notes was also adequate, he said.

“We’re supposed to have a recession. We haven’t seen it yet. But as we go into 2024 and 2025, it could very well happen. The market could go down on the first year then bounce back. A recession could easily limit your potential upside. If you end up positive or slightly negative, the payout of the note would be just right,” he said.

The notes also fit a particular mindset.

The 2x leverage and the buffer catered to clients with a “not so optimistic” view of the near future, he said.

If the performance is negative, investors have a guaranteed amount of downside protection. If the index’s return is mediocre, the leverage will enhance their return, he said.

“It’s built for somebody who is a little bit cautious, a little bit nervous.

Raising the cap

“If you’re a raging bull, the cap will definitely be an obstacle. But raging bulls are never going to accept a cap anyway.

“I like the note. I would be hard-pressed to find something negative with it,” he noted.

He pointed to one exception however, which was the 2% fee, which is disclosed in the prospectus.

“2% on a two-year note... That’s darn high,” he said.

“I have to imagine that if they reduced the fee, they could probably raise the cap.

“Other than that, it’s a nice offering.”

UBS Financial Services Inc. and UBS Investment Bank are the agents.

The notes settled on Tuesday.

The Cusip number is 90289Y587.

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